Should Bill Gates Have Let Paul Allen Keep Paul's Microsoft Shares When

WILLIAM C. STALEY

Business Tax Planning ______April, 2011

SHOULD BILL GATES HAVE LET PAUL ALLEN KEEP PAUL’S MICROSOFT SHARES WHEN PAUL LEFT IN 1983?

Paul Allen and Bill Gates owned the Microsoft partnership 40%/60% until 1977, then 36%/64%. Current CEO Steve Ballmer joined the company in 1980. The Microsoft partnership reorga- nized as a corporation in June, 1981, with 96% of the stock owned by Bill (53%), Paul (35%) and Steve (8%).

The IBM personal computer said “No way.” So Paul kept his Mi- came out in August, 1981 -- with a crosoft shares and his seat on the Microsoft operating system and Mi- board of directors. crosoft software. In January, 1983 Time Magazine named the personal Paul said “If he’d been willing computer the “Person of the Year” for to offer something close to my asking 1982. The IBM XT, with a 10MB price, I would have sold way too hard drive, 128kb RAM and an 8-bit soon.”1 bus, debuted in March, 1983. Zork, a popular computer game then (“Pick up axe”, “There is no axe here”), was all 1 Paul Allen, Microsoft’s Odd text, with no audio or graphics. Couple, Vanity Fair, May, 2011, http://www.vanityfair.com/business/features/2011/0 Paul was diagnosed with Hodg- 5/paul-allen-201105, adapted from IDEA MAN, by Paul Allen, to be published in May, kin’s disease, a form of cancer, and 2011 by Portfolio, a member of the Pen- treated successfully in 1982. Just be- guin Group (USA) Inc. “When Vern Ra- fore Paul Allen left his Microsoft job burn, the president of our consumer prod- in February, 1983, Bill Gates offered ucts division, left to go to Lotus Develop- to buy Paul’s Microsoft shares at $5 ment, the Microsoft board had voted to buy each. Paul said he would not even back his stock for three dollars a share, discuss less than $10 per share. Bill

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Later in 1983 Microsoft intro- Steve made his fortune in Microsoft duced its first mouse and its first ver- stock options.3 sion of Word. In November 1983 it announced (but did not ship until The viewpoints. One view is 1985) its first version of Windows. “They are all filthy rich, who cares if Microsoft went public in March 1986 one got more that the other?” So let’s at $21 a share. take it down five decimal places and assume all their wealth is Microsoft Adjusted for splits, the shares (“MS”) shares. In this hypothetical Paul kept in 1983 are now worth world, Bill has $5.6 million after giv- $7,376 each. Because Paul kept those ing away $2.8M. Steve has $1.4M shares, he was eventually worth and Paul has $1.3M. In other words, $13 billion, ranking 57th on the most Paul has participated in MS profits recent Forbes magazine list of billio- about the same as Steve. naires. Paul has given over $900M to charities. Bill Gates is worth $56B and is the second richest person in the world, after 17 years at No. 1.2 Bill has given $28B to charity, including to 3 Microsoft Co-Founder Hits Out at Gates, his foundation. Bill and Paul have Wall St. Journal 3-30-11; Fredrick E. Al- pledged to leave their wealth to chari- len, Bill Gates Tried to Screw Paul Allen? ty. Steve Ballmer is worth $14.5B and What’s the Surprise?, blog on is the 46th richest person in the world. www.Forbes.com 3-30-11; Key Events in Microsoft History, (footnote continued from preceding column) www.microsoft.com/downloads; www.billgatesmicrosoft.com; Steve Ballmer which ultimately cost him billions of dol- at www.ReferencesforBusiness.com; lars. I knew that Bill hoped to pressure me http://www.forbes.com/profile/bill-gates; to sell mine the same way. But I was in a http://www.forbes.com/profile/steve- different position from Vern, who’d ballmer; Billion-Dollar Donors, jumped to Lotus in apparent violation of his www.Forbes.com, 8-24-09; Allen Steps Up employment agreement. I was a co- to Buffett and Gates’ Billionaire Challenge, founder, and I wasn’t leaving to join a Forbes.com, 7-15-10; Steve Ballmer at competitor.” www.wikipedia.com (stating without cita- tion that Steve made his fortune in MS 2 Carlos Slim of Mexico is currently stock options). No. 1.

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Should Paul have participated to since then Paul has participated just as this extent in the profits from Win- any other investor.5 dows, MS Office, Internet Explorer, mice, keyboards, Xbox and other Bill and Steve might now wish hardware -- all projects started after that most of Paul’s shares were bought Paul left as an officer? Paul was there back by MS, Bill or Steve in 1983, when MS took over the operating sys- when Paul left as an employee. By tem and programming language of keeping his shares, Paul was able to IBM personal computers. Steve was elect himself to the Board of Direc- there when MS took over a much big- tors.6 ger computing world. Steve she- pherded MS through antitrust battles Cash flow and white-hot with both the USA and the EU -- and growth. If Paul had a 35% interest in MS survived. Steve took the reins as MS in 1983 and MS bought it back, CEO when Bill retired. Of course, the share ownership would become Steve also received a salary from MS Bill (83%, from 53%), Steve (12%, in the years after 1983 when Paul did from 8%), others (6%, from 4%). To not. But if Steve’s salary was com- buy Paul’s shares, MS would have mensurate with the value of his servic- needed to redirect scarce after-tax cash es, shouldn’t Steve have earned more away from new projects to paying than Paul from the shares? Paul. MS would probably have paid for Paul’s shares mostly with a prom- Paul would probably say (a) that he deserves his share of the MS profits (footnote continued from preceding column) because he was there for the formative years of 1975 to 1983, and (b) that he a tribute to my contributions, and in the put his valuable stamp on the company hope that I would continue to add value to then. Also, he contributed as a direc- the company I’d helped create,” said Paul tor to the company’s success after in the Vanity Fair excerpt from his book. 1983.4 MS went public in 1986, so 5 But buyers at the IPO invested much more cash in MS than Paul.

4 “[After resigning as an officer in 6 If Paul had been bought out, wheth- 1983,] I retained my seat on the board and er he served on the Board would have been was subsequently voted vice-chairman -- as up to Bill and Steve.

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issory note, making monthly payments That would give Bill and Steve time to for 3 to 6 years. raise debt or equity to fund the balloon payment to Paul. If Bill bought Paul’s shares, Bill would then have owned 88% of the Bill could have considered hav- company. If Steve bought all of ing MS set up an Employee Stock Paul’s shares, Steve would then have Ownership Plan. The ESOP would owned 43% of the company. Either of borrow from a bank to buy all of them would have planned on paying Paul’s shares for cash. Paul would for Paul’s shares with dividends from pay no tax if he reinvested in stock or MS. With MS in a white-hot growth bonds of US companies. Paul could mode, it probably was not attractive to access the sale proceeds with margin take scarce after-tax cash from the loans. MS would make deductible corporation, distribute it to the share- plan contributions to the ESOP to ena- holders who would pay tax again on ble the ESOP to pay its bank debt. the dividend, so that one shareholder Bottom line: Paul might take a lower could use the after-tax cash to pay for per-share price for a tax-free sale and Paul’s shares. Which probably ex- MS would pay for the shares with pre- plains why Bill did not offer more than tax dollars. The ESOP does not fit a low-ball price for the shares. In a every situation. But when it does, the nutshell, buying Paul’s shares might tax benefits are amazing. have made MS less likely to meet its commitments to IBM – it might have Bill could have suggested that killed the goose that laid the golden Paul use a charitable remainder trust to eggs. sell some of the shares, generating a charitable contribution deduction in Bill should have kept talking. 1983 that might have saved Paul Bill still had several alternatives. He enough in taxes to induce him to ac- could have accepted Paul’s $10 per cept a lower price per share. share price, but paid it over 7 to 10 years, to lower the payments. If MS The key point is that Bill could bought Paul’s shares, Bill and Steve have tentatively accepted Paul’s price could have pledged some of their and continued to negotiate a deal that shares to secure the MS debt to Paul. would leave MS with cash to operate If Paul balked at this offer, MS could and grow. However, no matter how have provided a 3-year note amortized the deal was structured, it would cause over 7 or 10 years with a balloon. MS to grow at a somewhat slower

rate, because cash would be diverted Paul’s 1982 cancer scare shows from growing MS to paying Paul. that it would have been smart for MS to buy life insurance on Bill and Paul, Planning in advance for a if the buy-sell agreement had been in stock transaction. In 1981 when MS place in 1981. If Paul’s treatment had incorporated, Bill and Paul should not been successful, MS could have have considered a “buy-sell agree- bought Paul’s shares for the cost of a ment.” (Did you know I was going to few years of life insurance premiums. get to this?) The agreement would The life insurance might not have been have said that if either Bill or Paul very expensive, since Bill and Paul died, became eligible for disability in- were both young men.8 surance or walked away from the business, MS would have an option to Another key point: If Bill and buy all of their shares. If MS did not Paul had put a buy-sell agreement in buy all of the shares, the remaining place in 1981, they would not have shareholder could buy them. A me- needed to argue about the purchase thod of pricing the shares would be price in 1983. (More accurately, set: probably by appraisal. The they would have already had that ar- agreement would give each of them a gument when they were negotiating right of first refusal to buy if the other the buy-sell agreement). When Paul wanted to sell to anyone else. If MS got sick, Bill and Stave would not was an S corporation, the agreement have to anguish over whether they could have protected that status. Paul should fire Paul and try to buy his could have asked for close corporation shares. If Paul was sick enough to status for MS and a provision in the collect disability insurance, his shares agreement that would name him Ex- could be bought (at the option of MS ecutive VP while he held shares and and Bill), his employment and salary 7 retained his mental abilities.

8 It’s better tax-wise if Bill and Paul 7 Otherwise, Bill could name two out each owned a policy on the life of the oth- of three directors and Bill’s directors could er – a “cross-purchase” arrangement. But terminate Paul’s employment and/or re- if Paul had died, an “entity-purchase” ar- move Paul as an officer. (As long as Paul rangement -- with MS buying Paul’s shares kept his big block of shares, he could elect -- would have been far better than no life at least one director on a three-seat board.) insurance and no buy-sell agreement.

payments would end and the disability Your own “Paul Allen” situa- insurance payments would begin. tion. Although I did not speak with Bill, Paul or Steve, I have worked With 8% of the shares, Steve with many business owners in their probably would not be in this agree- positions. The best time to get serious ment between Bill and Paul. Steve about a buy-sell agreement for the and each employee in the 4% block of principal shareholders is the first week shares would have his or her own that they think “OK, this might actual- “buy-back agreement” with MS. As ly work. Our ideas and hard work are an example, if Steve ceased to be em- now generating real cash flow.” ployed by MS, MS (and no one else) When one shareholder gets back bad would have an option to buy his shares lab tests, it’s too late. It’s also unlike- back, probably for one cash payment. ly that a buy-sell agreement will get signed when one of the principal With agreements like these in shareholders has a difficult marriage. place in 1981, Bill still might not have wanted to use scarce after-tax cash to The minute that an employee or buy Paul’s shares in 1983. But he family member receives shares is the would have had the option to do so, right time for his or her buy-back and there would have been a mechan- agreement. Any delay will disadvan- ism to set the price. Of course, Bill tage the company. could have said to Paul “The agreement calls for a price of $10 per share, I would be pleased to discuss with but we can’t afford that right now. you ways to protect the shares of your Would you take $5 per share and we business (or your client’s business) will shorten the payment period from from a “Paul Allen” situation. the 60 months in the agreement to 36 months?” They could still negotiate, -- William C. Staley but the agreement would be the new (818) 936-3490 default. www.staleylaw.com

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