Shared Pie, Bigger Pie: Making ESOPs work for your startup

What is an ESOP?

ESOPs enable companies to offer and grant securities to employees, contractors, directors and advisors, so they can receive an ownership interest in the company. In Australia, the most common form of security offered and granted by startups under an ESOP is options. Options provide the holder with a right to be issued shares in the future, usually in return for a cash payment (known as the ‘exercise price’).

There are multiple ways to structure an ESOP; this article focuses on some of the issues that need to be managed in relation to startups granting options to recipients who are Australian tax residents.

What to consider when implementing an ESOP?

Start-up concession

Unless a concession applies, the difference between the market value of the options granted to a participant under an ESOP and the amount that the participant pays in cash for those options (which is normally nothing) will be deemed to be taxable income for income tax purposes in the financial year in which the participant receives the options. This is usually a problem that startups need to resolve, as the participant will not have realised any actual value from their options, and will most likely not have the funds to pay the income tax, when it needs to be paid.

As a result, most startups structure their ESOP as a ‘start-up concession scheme’. Under the start-up concession, ‘ESS interests’, such as shares or options, acquired at less than market value do not have the discount treated as taxable income; the ESS interests will instead be treated as capital gains tax assets. To be eligible, a startup must, amongst other things, be less than ten years old, not listed on a stock exchange and not generate revenue greater than $50,000,000.

For an option grant under an ESOP to comply with the requirements of the start-up concession:

• the exercise price of the options must not be less than the market value of the underlying ordinary shares when the options were granted;
• a minimum holding period of three years, or when the employee ceases to be employed, if earlier, must apply to the options and the underlying ordinary shares; and
• the recipient’s shareholding in the company cannot exceed 10% immediately prior to the option grant (and any options already held by the recipient are counted for this purpose).

The startup must also comply with various reporting requirements to both the Australian Taxation Office (ATO) and the participants under the ESOP.

What to consider when offering and granting options under an ESOP?

Corporations Act

When offering options under an ESOP, startups will need to rely upon an exception to the requirement to prepare a ‘disclosure document’ (such as a prospectus) under the Corporations Act 2001 (Cth). The exceptions most used in connection with ESOPs are:

• the senior manager exception, which permits companies to offer and grant options to a person “who is concerned in, or takes part in, the management of the body” without a disclosure document; and
• the ‘20/12’ exception, which allows companies to raise up to $2 million from up to 20 persons in any rolling 12-month period without a disclosure document.

Companies must also be careful not to give any recommendations or opinions that are intended to influence the decision of persons to participate in the ESOP, and not make offers under the ESOP to persons during unsolicited meetings or telephone calls.

Exercise price

As noted above, for the start-up concession to apply, the exercise price of the options must not be less than the market value of the underlying ordinary shares when the options were granted. The ATO has issued a ‘safe harbour instrument’ that sets out two different valuation methodologies that startups can use to determine the market value of their ordinary shares for this purpose.

Vesting regime

Options are often granted under an ESOP to a recipient in consideration of future services. Accordingly, it is important to have a mechanism that allows the recipient to ‘earn’ their options by performing the relevant services.

The mechanism most used by startups is a vesting regime. Under a vesting regime, the ESOP participant cannot exercise the relevant options unless and until a specified period passes or an event occurs.

Vesting is often time-based, with the vesting of options commencing after a certain point, known as a cliff. A common vesting regime involves options vesting across four years, with 25% of options vesting at a one-year cliff and the remaining 75% vesting at monthly or quarterly intervals over the next three years. Vesting can also be performance-based, which means that the options will only vest if the recipient meets specific performance objectives or KPIs.

Treatment of leaver’s options

If the ESOP participant leaves the startup before the end of the time-based vesting regime, or does not satisfy the specific performance objectives or KPIs under a performance-based vesting regime, their unvested options will stop vesting and will lapse.

The startup may also have the right to buy back and cancel the vested options of a participant who has left the startup. The price paid for vested options often depends on whether the participant is a ‘good leaver’ or ‘bad leaver’. A participant may be a bad leaver if they ceased working at the startup due to misconduct and accordingly will only receive a nominal amount for vested options. Alternatively, a participant may be a good leaver if they leave the company on good terms and will generally be paid the fair market value of their options. Companies may also decide that a good leaver can retain some or all of their vested options.

If you need assistance with an employee share option plan for your startup, please contact a member of Addisons’ Venture Capital & Startups team.