Figuring out the right employee share scheme (ESS) structure for your startup at the beginning and as you grow can be a headache. Rather than being a hassle, we want to help simplify this process.Once you have an effective ESS in place, it helps attract and retain great talent and align employees with the long-term vision of your company–a winning combo.
Selecting the right structure comes down to 3 factors:
- What are you eligible for?
- What is the most tax effective?
- What will drive the right behaviours?
With those 3 elements front of mind, the most common ESS structures we see within our portfolio at AirTree are:
- Early-stage startups (<10 years and <$50m turnover) typically use the ESOP (with Start-Up Tax Concession) structure. Some startups will carve out Zero Exercise Price Options (ZEPOs) for junior employees with small grants for ease and simplicity.
- Growth stage startups (>10 years, or >$50m turnover) typically use the ESOP structure, either with or without the Start-Up Tax Concession*, with a strike price set at or above Fair Market Value (FMV). Some growth-stage companies are beginning to use ZEPOs but generally only with performance rights attached or for junior employees when issuing small grants.
- Later-stage startups (>10 years and >$50m) typically use some form of ESOP with a strike price set at or above FMV. Similar to growth-stage companies, some will use ZEPOs with performance rights, or for junior employees when issuing smaller grants.
General rules of thumb aside, let’s walk through the specific eligibility requirements for the different structures.
ESOP (with Start-Up Tax Concession)
If you answered yes to the first 4 questions in the decision tree, you’re eligible for the Start-Up Tax Concession. Congratulations–this automatically gives your employees tax-deferred status on grants and capital gains tax benefits on disposal.
Before discussing this structure's nuances, let’s look at the eligibility requirements in more detail:
- Is the option instrument you’re providing convertible into ordinary shares? The answer is yes in 99% of cases within the AirTree portfolio. There may be preference shares in the capital stack, but typically ESOP converts into ordinary shares, as opposed to any other share type.
- Is there an individual that holds more than 10% of a stake in the company? This is typically an isolated case unless a founder participates in ESOP top-ups. Outside of that scenario, it is less common to see individual allocations breach this threshold.
- Is the company less than 10 years old? As early-stage investors, this is the case for many companies in AirTree’s portfolio.
One watchpoint is that if you’ve acquired or merged with a company, it also captures subsidiaries, triggering the “No” path if the subsidiary is >10 years old.
- Is your turnover <$50m? Your company has an aggregated turnover of no more than $50m in the most recent income year before the employee acquired shares or options.
From here, the path splits into two directions that will decide how you determine the minimum strike price you can offer:
Net tangible asset (NTA)
The NTA method is an ATO-issued safe harbour valuation methodology which your startup can use to value shares for an ESS. Under the NTA method, a startup’s valuation is calculated using the following formula:
NTA=(Net tangible assets** – Preference shares***) / Number of outstanding ordinary shares****
Typically, this method results in the strike price set close to nil as startup’s have few or no tangible assets (e.g. receivables, property, equipment and inventory).
Your startup is eligible to use the NTA if you satisfy the 2 limbs below:
- Your company has raised less than $10m in the last 12 months (typical of many seed stage companies); and
- Your company ha annual turnover of less than $10m OR is <7years old (opens up the methodology to growth-stage companies that haven't raised in the previous 12 months)
Fair market value (FMV)
If you don’t qualify for the NTA methodology, there is a second safe harbour available for Start-Up Concession options–FMV. In this scenario, your CFO can complete your valuation, or a qualified valuer can determine the valuation in writing to be endorsed by the directors. Nevertheless, we typically recommend our portfolio companies engage a third-party valuer to ensure it’s tax compliant.
Importantly, both methodologies set the strike price floor you can offer ESOP grantees. In most situations, this typically results in a discount to the company's most recent fundraising round. As a result, many companies set the strike price above the minimum allowable strike price to better align incentives, particularly with investors and founders.
Your company typically defaults to a standard ESOP with a strike price floor at FMV if it’s over 10 years old and/or generates over $50m turnover.
This structure is similar to the ESOP with Start-Up Tax Concession plan, but the individual tax benefit is substantially less as they don’t receive the Capital Gains Tax discount of 50% on disposal.
Zero Exercise Price Options (ZEPOs)
ZEPOs are options granted to an individual with a zero exercise price.
ZEPOs are usually used in one of two scenarios:
- You’re issuing small tranches of options to junior employees. It’s simple and easy to explain to a cross-section of your employee base.
- You want to provide your employees with a greater net benefit upfront while limiting dilution. To ensure incentives are aligned with investors and other early shareholders, we typically see performance hurdles attached to ZEPOS. These hurdles may be based on individual performance, company performance, and/or a fundraise or exit outcome.
If you’re not issuing options for ordinary shares or an ESS participant has a stake >10%, you’ll have to seek an alternative structure. Here’s a brief overview of some alternatives to discuss with your tax advisor.
Individuals in Australia with a stake greater than 10% in a company aren’t eligible for Start-Up Tax concessions and must pay tax upfront or rely on a tax deferral structure. Neither of these alternatives are usually a good outcome for the individual as:
- There’s no liquidity or cash to pay the tax upfront; and/or
- They won’t enjoy the benefits of the CGT 50% tax discount on gains
In this scenario, an Indeterminate rights scheme may be the best structure for issuing grants. This structure provides grantees with a right, at a future time, to acquire a specified number of shares or to receive a payment in cash equal to the value of the equivalent shares. The right granted is indeterminate, as it’s up to the company's board to determine if it will issue equity or make a cash payment.
An Indeterminate right isn’t usually subject to tax on grant. Instead, it becomes subject to tax when the company determines what form the right will take–equity or cash. When determined, the grantee is typically subject to income tax on the value of the grant at the grant date. The grantee must subsequently amend their tax return for that grant year. If the right is received in equity, any gain should be subject to capital gains tax and attract the 50% CGT discount if the right is held for greater than 12 months.
Loan-funded share plan
If your company doesn’t qualify for the Start-Up Tax concessions, a loan-funded share scheme is an alternative structure to make grants in a tax-effective manner. You can also use a loan-funded share scheme if you want to issue grants over shares that aren’t ordinary shares.
Loan-funded share plans involve the provision of a limited recourse loan to employees where the loan is used to subscribe for equity at fair market value. Because the grantee is paying fair market value for the shares, they aren’t receiving any upfront benefit. As a result, they aren’t obligated to pay income tax at the time of issue.
While loan-funded share schemes offer concessional tax treatment, they come with more complex tax and common law issues. They also involve employees becoming actual shareholders from Day 1, giving them rights that option holders do not receive.
Accordingly, loan-funded share schemes are more common in older companies (whose inception pre-dates Start-Up Concessions) and/or later-stage or PE-backed companies who wish to attract and incentivise a small number of senior executives with concessional capital gains tax treatment on an exit.
Payroll tax watch outs
Regardless of which ESS structure you use, payroll tax is often a sleeper issue that isn’t given enough thought at the time of grants. Each State in Australia has different payroll tax rules, but here are a few things to be mindful of:
- Granted options can either be assessed at the time of grant (when the options are issued); at exercise, or after 7 years (that’s the cut-off period).
- Typically, most startups overlook their choices and default to assessment at exercise (liquidity event) or 7 years. This is likely to generate a larger tax obligation if the value of the shares have appreciated since grant, and can be a surprise to companies at that point in time.
- If options are assessed at grant and an employee forfeits the option (normally due to being a leaver), you can receive a credit for the already paid payroll tax. This ensures there is no payroll tax paid on options that ultimately aren’t exercised.
- If the options aren’t assessed at grant, you can’t go back and amend the payroll tax assessment*****
- If you decide to be assessed at grant, be careful with using the NTA approach–not all states accept the NTA approach and the payroll tax liability can be materially increased in those states as a result.
- Nevertheless, most companies prefer the payroll tax impost to be another transaction cost associated with a future liquidity event.
🙏 We’re lucky to collaborate with partners who share our Open Source ethos. Thank you to Joel Cox, Partner at DLA Piper Australia, for being a legal sounding board, Jake Berger, Partner at Pitcher Partners, who helps out a bunch of our portfolio companies and is especially excellent at the dark art of growth and later stage plans including setting up founder schemes.
This article does not constitute financial or tax advice. You should seek financial and tax advice before acting or relying on any content. Check out our Open Source VC list of recommended advisors to help you out.