Slicing the Pie – How ESS and ESOP arrangements work

Under the ATO (Australian Tax Office), new startups are empowered to attract top talent and retain them through the use of employee ownership schemes.

These types of schemes come in two forms: Employee Share Schemes (ESS) and Employee Share Option Plans (ESOP). Both schemes let employees buy or receive shares (or rights to) in the companies that they work for.

ESS and ESOP are often used as a form of compensation to make up for the difference in salary wages against the job market rate.

Sometimes, certain companies allow their employees to buy shares from the company, or as a form of a loan.

Depending on the conditions of the scheme, employees may be required to sell their shares back to the company when they leave the company.

With an employee ownership scheme, startup founders without the financial clout of big companies can keep their talents by offering equity of the company.

At the same time, the founders can quickly align their workforce’s goals with that of the company.

*Do note that the terms ESOP (Employee Share Option Plan) and ESS are used interchangeably in Australian content.
However, ESS is the more common term because Australia uses the term ‘shares’ instead of ‘stocks.’

The story of the part-time masseuse who joined Google when it had only 40 employees, and subsequently became a millionaire is a tale that many people are familiar with.
For years, employee ownership has always been at the core of countless Silicon Valley startups. Both Facebook and Google have produced thousands of millionaires through their stock option programs.

The dream of reaping big rewards through hard work is the key reason why employee ownership schemes are so prevalent in startup culture, drawing thousands of talent to Silicon Valley every year.

Several employees that hailed from wildly successful startups do often go on to build their own companies, or they become angel investors on fledging startups, creating a meaningful cycle of entrepreneurship.

Ambitious founders with foresight should start fostering an entrepreneurial mindset among their workforce since day one, so they can stay hungry and motivated to help the business grow strength-to-strength.

There are several key differences between both schemes.
With an ESS, the startup issues the employees with shares. These shares are typically vested over time. That means if the employee leaves the startup before all of their shares have vested, the startup can repurchase back any unvested shares.

Under an ESOP, the startup issues the employees with options to purchase shares. Similar to ESS shares, these options are vested over time too.

Only after an option has been vested, then the option-holder can exercise his or her option (such as purchasing a share).

The employee often pauses on exercising an option until a liquidity event occurs. The sales proceeds from the liquidation would allow the employee to pay for the exercise price. This is commonly a cashless exercise.

There are several other key differences between both schemes. Founders need to understand them so they can choose the scheme that suits their startup needs.

ESS – A startup must offer shares to 75% or more Australian permanent employees. They must have at least three years of experience working with the startup.

ESOP – There is no such requirement for ESOPs. The startup can choose to distribute options under EOS to as many employees as it pleases.

ESS – Shares are a straightforward concept for most employees. They own the shares in the startup from the moment it is issued to them.

ESOP – The concept of options less understood for most employees, which requires more education by the startup. Employees would also need to understand that they are not shareholders until they have exercised their options, and that their options are not necessarily less valuable than shares.

ESS – An employee is entitled to dividends, as long as the startup can declare dividends. Employees may find that holding shares is preferable to options in terms of sharing the profits of a company.

ESOP – Option holders do not own any shares, and therefore, they are not entitled to dividends.

ESS – All employees who possess shares have the right to attend and vote at the company’s general meetings. This can be a disadvantageous for the startup as it may overcomplicate the approval process.

ESOP – Option holders do not have voting rights as they do not hold shares.

ESS – In Australian law, a company can only have up to 50 shareholders. With an ESS, a scale up can easily exceed this limit. This can lead to an increase in the cost of any investment into the scale up, or a Chapter 6 compliance issue due to an acquisition of the startup.

ESOP – With ESOP, a scale up can circumvent the shareholder limit. Also, by structuring its ESOP to sell all options to the acquirer, the startup can avoid any potential compliance issues.

ESS – The employee has to pay a minimum of 85% of a share’s market value upfront. However, with the ATO’s ‘Safe-Harbour’ Net Tangible Assets (NTA) valuation method, it is possible to derive a small value.

ESOP – The employee only has to pay the exercise price for the option. Because a cashless exercise allows the employee to ‘cash in’ without any money from their pocket, most would choose to wait till a liquidation event to exercise their options.

Using an employee share option plan or employee share scheme brings several benefits to the company; these include:

Your workforce’s interest aligns with that of the shareholders and the company, keeping employees motivated to work towards growing the value of their holdings.

A rewarding ESS or ESOP can become an attractive reward to attract new skillsets on to your team, offering a compelling reason for them to stay with your company for the long haul through thick and thin.

When employees receive ownership, they are encouraged to create more value through their work, which leads to higher engagement and initiative towards solving key problems for the company.

ESOP or ESS let businesses offer more benefits to personnel that command top salary, without having to put a strain on their finances.

When employees become shareholders, they have a more vested interest to take on more responsibility towards their work duties.

When the workforce has a shared stake in the success of a startup, the divide between management and employees substantially shrinks as they come together to work as a team.

A sense of ownership can bring up the level of happiness amongst the workforce, which can do wonders in boosting employees’ overall productivity and job contentment.

While the benefits far outweigh the drawbacks, startup owners need to understand the potential risks of implementing an ESS or ESOP before any decision. Aspects to consider include:

As more shares are given out, the company owner’s share ownership becomes smaller. As more shares are issued to more employees, the share percentage of the main stakeholders shrinks.

This can occur when a startup does not experience any growth in share pricing over an extended period, causing employees to feel they have no significant impact over the share price outcome.
If the employees’ morale and expectations are not properly managed, it can lead to a dip in share price performance.

Like most company-wide initiatives, there are costs involved in setting up and administrating legal, accounting, and tax duties of an employee ownership scheme can become a burden on smaller organisations that are not financially equipped.

Since July 2015, the Australian Taxation Office (ATO) has introduced a set of startup concessions for employees participating in ESS and ESOP implemented by qualified startups.

With these startup tax concessions, the employee participating in the ESS or ESOP has the ability to defer tax on a share or option that they received from the company.

This means the employee doesn’t need to pay the tax until they have vested or exercised the option — with a financial benefit only occurring when a sale of the shares has been completed. Also, for the purposes of the capital gains tax discount from disposing of a share, the participant is seen as having received the share at the time the startup granted the share or option.

Normally, the 12 month period is considered from when the shares is acquired – the inclusion of option holding period is a big bonus.
For any startup to be eligible for ESS or ESOP concessions, first it has to be a private company. For a startup to be eligible for startup tax concessions, there is a list of criteria that must be met:

Any of the company’s shares or shares originating from any holding, subsidiary, or sister company cannot be listed on an approved stock exchange.

The company must be incorporated less than ten years before the end of the company’s latest income year, before the employee has acquired any shares or options.

The company should have a turnover of less than $50m in the latest income year before the employee acquired any shares or options.

The main business of the company is not the acquisition, sale or holding of shares, securities, or other investments.

The company must gainfully employ the workers that are acquiring shares or options at the time of issue.

Participants are not allowed to dispose of their options or shares within (a) three years from the grant date or (b) when his or her employment ends (whichever is earlier).

No other forms of shares or options can be granted to an employee under an ESS or ESOP.

An employee cannot hold a beneficial interest of over 10% of the shares in the company. He or she is unable to control over 10% of the maximum number of casted votes at a company’s general meeting

Perhaps the most vital factor that you should consider is how you can communicate the ESS or ESOP to your workforce.

The likelihood of your employees being involved in an ESS or ESOP before joining your startup will be low; hence many of them will have little idea on how employee ownership would work. Therefore, a company-wide program to educate your workforce will be crucial to helping them understand.

Employees will likely have several queries about how the scheme works or what to do, so you need to be highly transparent about the features of the scheme and provide as much guidance as possible.

Another factor to consider is the extent of contributions an employee ownership scheme can contribute to your startup’s goals. For example, if you wish to extend your company’s talent pool to include more global workers than local Australians, then an ESS may not be a suitable option for your startup.

Last but not least, you need to be fine with sharing some control over your company when you dilute your share ownership to your employees. The primary reason here is that most ordinary shares can carry voting rights to the company as well.