Employee Share Schemes (ESS) are an attractive option for many startups and small businesses. As a result of changes to the Tax Act in July 2015, employers can now offer tax benefits to employees who participate in an ESS. 

If you’re thinking about establishing an ESS for your company, read on to learn:

  • What is an ESS?
  • How to value your shares
  • How are options offered in an ESS taxed?
  • How to set an ESS up and;
  • The pros and cons of an ESS

What Is An Employee Share Scheme?

An ESS gives your employees the option to buy an interest in your company. You can structure an ESS in different ways, choosing how employees can pay for the shares and what kind of shares the employees are entitled to. 

Some methods of buying shares under an ESS include: 

  • Salary sacrifice
  • Loans from an employer
  • Full up-front payment or 
  • Remuneration for high performance 

There are three kinds of Employee Share Scheme interests offerable under a scheme: 

  1. Shares 
  2. Stapled securities 
  3. The rights to acquires shares and stapled securities (options)

An important distinction to be aware of with ESS is that there are non-concessional and concessional ESS schemes. Simply, this determines if your employees get a tax concession on the options they buy or if they do not get a concession. 

How Are Interests Offered Under Employee Share Schemes Valued? 

There are two methods for valuing the interests offered under an ESS. Depending on how the interests are valued, your company may be able to offer ESS interests for below market price. 

Option 1: Net Tangible Valuation Method

The first option that start ups are usually eligible for, is the ‘net tangible assets valuation method.’ The full details of how a valuation is made  can be found  here under ‘Method One’.

Essentially, it involves dividing the amount of tangible assets the company has by the amount of ordinary shares in the company. If eligible, start ups under this valuation method can offer shares under market value because usually they have very few tangible assets. 

The criteria your company must meet to be eligible is detailed below:

  • You do not reasonably anticipate there will be a change of control occurring in your company in the next six months from valuation. 
  • Your company did not raise more than 10 million dollars in the year before valuation. 
  • Your company is either a small business or has not been incorporated for more than 7 years. 
  • You must prepare a financial report for the year in which the valuation occurs. 

If you don’t meet the above criteria, you  will have to use the second valuation option. 

Option 2: Official Valuation 

This option is a more comprehensive valuation by your CFO or someone qualified to carry out a valuation. Described here fully under ‘Method 2.’ When valuing the shares, this method requires the valuer to take into account the following:

  • The value of tangible and intangible assets
  • The present value of anticipated cash flow
  • The market values of similar businesses
  • Control premiums, lack of marketability and key person risk. 

To summarise, there are two methods to value the interests you offer your employees, the net tangible assets valuation method and the official valuation method. Most startups would be eligible for the net tangible asset method. Using this valuation method, you will likely be able to offer ESS interests to your employees for below market value, creating a greater incentive for them to work hard and stay on in the company. 

How Are Options Offered In An Employee Share Schemes Taxed?

Changes to the Tax Act in Australia in 2015 created a criteria that, if met, allows for special tax concessions specifically for employees of startups participating in an ESS and buying options. 

There are two tax advantages that employees who buy options under an ESS receive:

  1. The option that is purchased will not be taxed until the sale of the shares occurs, deferring the tax the employee pays.
  2. When the employee does sell their shares, if it is after 12 months of receiving the option, they will be eligible for a 50% capital gains tax discount. 

How Do I Create An Employee Share Scheme That Receives The Startup Tax Concession?

To create an ESS and get the startup tax concession, a company must meet the eligibility requirements. 

To help you determine if you’re eligible we have compiled a series of questions. 

If you answer yes to all of them, then your employees are likely to be eligible for the start up tax concessions. 

  • Are you a company who is incorporated in Australia? 
  • Is your main business something other than investing? 
  • Are the shares or options in your company private? 
  • Does your company earn less than 50 million dollars a year? 

If you are eligible under the above criteria, there are a few more requirements you need to be aware of. These will allow your ESS to remain eligible.

  • Employees who hold more than 10% of the company’s shares cannot be granted options or shares under the scheme. 
  • If offering options, the exercise price cannot be less than fair market value at the time of the grant.
  • If offering shares, the price offered must not be less that 85% of market value. 
  • All ESS interests offered must be ordinary, not preference shares. 
  • ESS interests must be held for a minimum period of three years from the date acquired. 

Are Employee Share Schemes Worth It?

Like anything, ESS have their advantages and disadvantages. To help you decide if they’re worth it for your company we discuss ESS pros and cons below. 

Pros

  • An ESS aligns the interests of the company and the employees. Providing another level of incentivisation for your employees to work hard. 
  • An ESS can relieve the pressure of offering competitive salaries to attract talent
  • If employees are paying up front for shares, an ESS provides cash flow to the business. 
  • An ESS is also a good way to retain talent, as employees are invested in the company they are more likely to stay. 

Cons

  • Employee Share Schemes have administrative and start up costs. 
  • If the company loses value employee motivation and morale could be weakened.
  • An employer must consider the loss of control that is inherent in distributing the shares of a company. 
  • Equity can be a complex to understand and often employees don’t fully appreciate the value of options or shares (until the company exits and they get paid!)

Will I Need Legal Assistance/Advice When Creating An ESS?

Setting up an ESS is a complicated process. The ATO provides some guidance on how to set up an ESS without a lawyer or accountant to reduce administrative costs. However, any mistakes you make along the way could cost you more in the long run, so it’s better to seek advice and get it right. 

Getting advice from a lawyer and accountant would ensure your ESS is set up to get the best outcomes for your company. 

Need Help?

We can help with this! If you need help establishing your ESS, we’ve got you covered. You can reach out to us at team@sprintlaw.com.au or contact us on 1800 730 617 for an obligation-free chat.

About Sprintlaw

Sprintlaw is a new type of law firm that operates completely online and on a fixed-fee basis. We’re on a mission to make quality legal services faster, simpler and more affordable for small business owners and entrepreneurs.

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