Accounting & Tax, Startups

Employee Share Schemes: What to Look For

employee share schemes

Employee Share Schemes are becoming increasingly popular within the Australian startup ecosystem and provide startup founders with the opportunity to offer shares to their employees. Here’s what you need to know about your ESS.

An Employee Share Scheme, or ESS, allows a startup to offer shares to employees or provide them with the option to purchase shares. The tax treatment of Employee Share Schemes was changed in 2015 by the Australian Tax Office in order to make them more attractive to employees, which has resulted in an increase in the total number of Australian startups offering ESSs.

Establishing an ESS, however, can be slightly complicated for new startup founders and employees alike. This article will highlight the key components of an Employee Share Scheme that should be considered by employees offered options rather than shares via ESS by an employer.

Options

An employer offers an employee the option to purchase shares in a company under the terms of an Employee Share Option Plan. It’s important to note that an option provides an employee with the right — not the obligation — to purchase shares in the company. An option delays the creation of a share until a date in the future.

Vesting

Vesting refers to the amount of time an employee must wait until they are able to act on or sell the shares they own. In general terms, options vest based on the length of time an employee has been employed by a company. The standard amount of vesting time within the Australian startup ecosystem is generally between three to five years, with options vesting at intervals during this time period.

An employee with shares that vest at 25 percent for each year the employee is employed, for example, is able to sell 100 percent of the shares they own after four years. Within this example, the employee shares vest at a rate of 25 percent after one year, 50 percent after two years, 75 percent after three years, and 100 percent after four years.

An employee is only able to exercise their options after all options have vested. Any vested options will lapse if an employee leaves a company before all options vest. In some cases, an employee may be obligated to sell some or all of their vested options in this scenario.

Exercise Price

Employee Share Scheme documents wild define the price an employee must pay in order to exercise an option. This price is referred to as the strike price or exercise price.

In order to benefit from ATO tax concessions regarding ESSs, the strike or exercise price must be at least the fair market value of a share in the company on the date the startup provided the option to the employee. Companies are able to calculate the fair market value of shares on this date using safe harbor valuation methodologies.

The safe harbor valuation methodologies are issued by the Australian Taxation Office and consist of just two methodologies. The first is a formal valuation, while the either is a net tangible assets test. Australian startups must satisfy specific eligibility criteria in order to use the latter test.

Buying shares is associated with risk. A shareholder purchases shares in the hope that the growth of the company that they hold shares in will result in a growth in the value of the shares they hold. An Employee Share Scheme provides employees with the option to purchase shares at the exercise price which, should the share value of a company significantly increase over time, be substantially lower than the current market value. This scenario can result in employees generating significant profit when they sell.

It’s important to note that options do not provide employees with either voting rights or the right to dividends.

Disposals

An employee must hold the options or shares provided to them through an ESS for a minimum of three years in order to benefit from the ATO’s startup tax concessions. This rule is applied unless an employee leaves a company or in a number of other limited circumstances.

An employee, however, typically does not dispose of options or shares unless there is an exit event.

An employee that chooses to exercise options and purchase shares must comply with either of the following:

● When exercising options and purchasing shares an employee must enter into a shareholder’s agreement; or
● When exercising options and purchasing shares an employee must sign a deed of accession agreeing to be bound by the terms of a shareholder’s agreement

After an employee exercises options to buy shares and becomes a shareholder, the shareholder’s agreement governs the disposal of any shares.

Eligibility Criteria

In order to qualify for the ATO’s startup tax concession, a startup must meet specific eligibility requirements, which include:

● The startup must be an Australian resident with at least one director who is an Australian resident
● The startup must not be listed on any stock exchange
● The startup must be incorporated for less than ten years
● The aggregate annual turnover of the startup must be less than $50 million

The exercise price must reflect the market value of the shares on the date the company granted options to the employee through the Employee Share Scheme. Other criteria that must be met by employees also include:

● An individual employee must not possess more than 10 percent of the company
● The employee must hold the options of shares for a minimum of 10 years.

Key Takeaways

An employee that has been given the option of participating in an Employee Share Scheme by an employer should take care to ensure that they are aware of all critical component of the scheme. These components include options, vesting dates, exercise price, disposals, and eligibility criteria.

If you are an Australian employee that has been offered an ESS by your employer, or if you are an Australian startup founder considering offering an ESS to your employees and you’re not sure how an ESS works reach out to Fullstack for comprehensive guidance and advice today.

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