The ins and outs of employee share schemes (minus the financial jargon)

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As successful startup founders and business owners know, having skin in the game is the ultimate motivator. 

Thankfully, Australia’s regulations on employee share schemes (ESS) recently changed making it easier for businesses to use these schemes so employees at all levels can share in the growth they help create. 

We help our startup and scale up clients assess whether an ESS is right for them and if so, we help set it up and keep it on the right side of the tax system. Here, we share our knowledge on the financial side of an ESS to help you understand how it works. 

What is an employee share scheme? 

An ESS is a plan that offers employees shares or options in your company. 

You probably know what shares are but perhaps you’re not so familiar with options. Basically: An option holder in a company has the opportunity to buy shares once certain conditions occur. If they exercise their option at that time, they become a shareholder. 

All kinds of companies can use these schemes, from startups to SMEs. The key word there is ‘companies’ – you do need to be one.

What’s in it for everyone?

As a startup, an ESS can help you attract or keep talent by giving them shares or options to make up for paying a lower salary than they could get in a more established business. 

As a more traditional business, an ESS can help you keep staff during more challenging times. If you need to reduce salaries, an ESS can help you make up some of the difference, showing your team you’re serious about keeping them on and working through tougher times together.  

No matter what type of company you are, an ESS provides an incentive for your team. If your value goes up, so do their shares. In other words, they have skin in the game. 

An ESS usually includes an entitlement for employees to earn more options (called vesting) over time. This provides a further incentive to stay focused on achieving goals together. 

Why not give your team discounted shares instead?

When buying shares or other assets, it’s always better to do it at a discount (just like buying a house for a cheap price). 

And yes, you can issue your employees with shares upfront instead of using an ESS. But unless you do this early enough when the value of the shares is low or nil, your employees will be taxed on the discount because it will form part of their taxable income. 

By contrast, an ESS is tax-friendly because employees don’t need to pay tax on their share or option until they sell it and when they do, they should be eligible for a capital gains tax discount of 50% (as long as they’ve owned the shares for more than 12 months). 

There is also extra icing on the tax-friendly cake for startups, as long as you don’t have many tangible assets. This means you can offer your team an employee-friendly option exercise price (that’s the price they’ll pay to turn their options into shares). More on this below.

How did the government make things easier?

In March 2022, the government included changes to ESS regulations when announcing the Federal Budget. The changes, which came into effect as part of the Budget Measures Bill, make it easier for businesses to use employee share schemes. 

They include:

  • Allowing unlisted companies to offer an unlimited number of shares, of an unlimited value, as long as the employee is not charged more than $30,000 a year for them (up from a $5,000 a year cap)
  • Allowing employees to accrue up to $150,000 worth of shares over a five year period
  • Making it possible for independent contractors to receive the same treatment as employees and directors in an ESS (where there is no payment to participate)

The fine print (eligibility)

Like all things financial, there are eligibility requirements for an ESS.

First up, you need to be an incorporated company in Australia (within the last 10 years) whose main business is not investing. Investment banks need not apply.

You can’t grant shares or options to an employee who holds more than 10% of your company’s shares or controls more than 10% of the vote at a general meeting. Also, your company can’t be earning a heap – aggregated turnover in the last income year must be under $50 million. 

And the rest:

  • Shares/options in your company can’t be listed on a public stock exchange
  • If the ESS is for options, the share price must be at least 85% of fair market value (unless eligible for the Safe Harbour Valuation)
  • If the ESS is for shares, you must offer shares to at least 75% of your Australian resident permanent employees who have completed at least three years’ service
  • If the ESS is an options scheme, employees must pay at least fair market value to exercise the right
  • All the options or shares relate to ordinary (not preference) shares
  • Employees are able to sell their shares/options either when their employment ends or after three years of the grant date 

Reporting to the ATO

It’s also worth knowing that with an ESS comes annual reporting obligations to the ATO.

These include:

  • Providing an annual ESS statement to employees by 14 July after the end of the financial year (which ends on 30 June). They need this for their tax returns
  • Providing an annual report to the ATO detailing any employee shares issued or options vested during the financial year (ending 30 June)

Penalties apply if you don’t fulfill these obligations.

If an ESS is right for you, reporting obligations shouldn’t put you off using one. Especially not when there are some great (if we do say so ourselves) startup-focused accountants who can handle this for you 🙂 . 

Valuing your company for an ESS

If you’re allocating shares or options in your company, you’ll need to know what they’re worth. 

You can use a formal valuation (as long as it meets the ATO’s Safe Harbour Guidelines) or you can use a simplified valuation method if you meet the ATO’s Net Tangible Assets Test. As mentioned above, this usually means you can keep the value of shares down (lower than market value), which is good for employees because they’ll pay less tax and have the ability to earn bigger gains. 

The criteria for this test include:

  • Your company hasn’t raised more than $10 million capital in the last 12 months
  • You don’t expect a change of control within six months of the share valuation
  • At the time of valuation, your company has either been incorporated for less than seven years or is a small business entity under the Income Tax Assessment Act 1997 (Cth)

You must provide a financial report for the income year of the valuation, compliant with accounting standards 

If you meet all the criteria – which many startups do – you can use this simple Safe Harbour Valuation method:

(A-B)/C = Valuation 

 Where: A means the company’s net tangible assets (excluding any preference shares on issue); B means the return on any preference shares on issue at that time if the shares were redeemed, cancelled or bought back; and C means the total number of outstanding shares (ordinary shares) in the company.

Many startups meet the test’s criteria because by nature, startups have few tangible assets.

Getting it right

Along with essentials such as a good culture, an ESS can be an affordable and tax-effective part of your employee plan, helping you attract and retain a motivated team as you grow.

It does need to be set up right, so it’s good to find a startup-friendly lawyer (like this team) and accountant who can walk you through it (like us!).

If you’re not eligible for an ESS, there are still other ways you can reward employees with shares in your company through things like recourse loans or premium priced option plans. But that’s a topic for another day.

…………………………………….

Just a reminder that this article isn’t personal financial or tax advice (you need to speak to us for that). If you’re looking for more free and helpful financial info, scroll through our blog and our resources, including a cashflow template. 

Photo at top by Fauxels from Pexels.

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