Why it might not be the best idea and what to consider instead

If you’re considering giving shares to an incoming co-founder or startup team member, you’re definitely not alone. 

As accountants and CFOs for startups, we’ve helped clients with employee equity plans for years. However, they are on the rise and we’re often asked questions about the tax implications of different equity options.

Here, I’m sharing general information to help you understand the difference between shares and share options from a tax perspective because there is a big difference, and it’s well worth understanding for you and your team’s sake.

But first, please remember this is not personal advice for your situation (you need to speak to us for that 🙂 ).

Shares versus share options

We all know what shares are – they give you a fraction of ownership in a company. A shareholder can vote at meetings and receive dividends as soon as they’re declared. If your employees have shares, you’ll likely have an Employee Share Scheme (ESS) in place. 

Share options are different. If someone has share options in your startup company, it means they have the right to buy or be awarded a share at a set price, before a set deadline. They can choose whether to use this right or not – they don’t have to. They can trade the share option or let it lapse at the deadline date. Share option holders cannot vote at meetings and can only receive dividends if they convert their options into actual shares. If you issue share options, you’ll have an Employee Stock Ownership Plan (ESOP) in place.

Why does it matter?

Especially in the early stages of a startup company, it’s tempting to think it doesn’t matter if you give co-founders/team members shares or share options. What’s the difference, if the company is valued at nothing or very little?

Even at later stages, many founders and operators don’t understand the difference and want to either give away shares for free or at a discounted price. Here’s why you need to think twice about that.

Tax implications of giving away shares 

If you give someone free shares, particularly if they’re an employee, they have to pay income tax on them every year they own them. 

If your company is already of significant value, that means employees will be paying a significant amount of income tax on shares each year, even though they won’t see any value from those shares for quite a while (assuming they want to hold them while your startup increases its value even more). 

If you try to get around this by structuring the gift as a loan to fund the shares you’re giving away, the ATO’s Division 7A regulations can kick in. This can get complex but in short, it generally means the loan will be treated as a dividend – subject to income tax – unless its paid back within the same financial year. 

Even if your company isn’t worth much just yet, shares involve more paperwork than share options. So if your employees have shares, you need to do filings with ASIC to satisfy its annual compliance requirements.

Tax implications of giving shares at a discount

If you make shares available to team members at a discounted price, the ATO’s Division 83A can apply. This means any discount of more than 15% of the shares’ market value is treated as assessable income upfront, making it subject to personal income tax. 

Many of our clients include share options as part of a remuneration package. Often, that includes a salary component and share options at a discounted rate (to make it attractive to the incoming team member) and subject to vesting conditions (to incentivise them to stay). Here’s an example.

You want to hire Sal, a software developer, so you offer her a base salary and share options in your company at a discount of 15%, on the provision that she’s with you for at least 3 years. 

After that time, if Sal decides to convert her share options to shares, and then sell them, she’ll be taxed on the gain calculated by the market value minus the discounted share option value.

So if the market value of the shares was $10,000 originally, she bought them for $8,500 (with her 15% discount). If she sells them 3 years later for $50,000, her profit of $41,500 will be taxed ($50,000 – $8,500).  This is not a deterrent for Sal (when considered against the tax implications of other options) – it’s just something to be aware of.

Tax implications of share options  

Compared with shares, share options are usually much simpler from a tax point of view. A share option holder doesn’t need to pay any tax at all until a.) they convert the option to an actual share and b.) they sell that share (at a profit).

As mentioned above, share option holders don’t have voting rights while shareholders do. Some team members might see this as a downside but in reality, many companies prefer to keep investors and team members separate on this front. 

It’s also worth noting that from your perspective, there are tax implications for your startup company if you issue shares (if they are worth something other than $0) but there are not usually tax implications for your company if you issue share options. 

The juicy side of share options  

In addition to the simpler tax position of share options versus shares covered above, there’s another (more exciting!) reason why your incoming co-founders or team members might be better off with them:

A share option gives the owner the ability to buy a share later on – when your startup’s shares are worth a lot more. They can do this for a very low amount of money (the value of their share option), and pocket the difference. 

Even better, if they’re an Australian shareholder, and your startup company qualifies as an early-stage innovation company (ESIC), they can access some pretty attractive tax breaks. Mainly, the ability to pay no capital gains tax on the profit made from buying a more valuable share at a lower price, as long as they hold the shares for at least 3 three years and sell them within 10 years. 

So how many share options should you give?  

Your next question might be: How many share options should you give to incoming co-founders or team members?

Ultimately, the composition of salary/wages and share options comes down to the stage you’re at, your cashflow position and projections, and what’s happening in the labour market for the type of expertise you’re trying to attract. It is worth seeking professional advice if you can, and at the very least, working through the numbers of different scenarios yourself. 

More info 

Offering equity in your startup to other people is a big deal (pun intended). It’s well worth taking the time to get it right, for everyone. 

There are a lot of other resources out there to help with this, including this thorough compilation. We are also happy to help so please do reach out if you’d like to chat.