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In March 2022, the government announced reforms to make it easier for businesses to utilise employee share schemes (‘ESS’) and reduce the red tape so that employees at all levels can directly share in the business growth they help to generate. These changes include:

  • amending the disclosure rules, 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). Employees will also be able to accrue up to $150,000 over a five year period; and
  • for employee share schemes where there is no payment to participate, independent contractors will receive the same treatment and receive the same regulatory relief as employees and directors who are participants in the scheme.

Putting together a cap table when raising your startup’s first round of capital can be daunting. We frequently speak with founders who are confused about including an employee share scheme (ESS) in the table. An ESS can relate to granting employees or contractors either shares or options to purchase shares. Startups commonly adopt share option plans to incentivise employees. Below, we explain how startup founders can incorporate an ESS into their cap table. 

Do I Need an ESS?

As part of your term sheet or shareholders agreement negotiations, your investor(s) may require you to implement an ESS. Shareholders will usually balance the benefit received from incentivising staff against the dilution they’ll undergo when deciding whether or not to adopt an ESS.

If shareholders approve the ESS, then it is typically around 10-15% of the company’s issued share capital.

Any shares issued (including options exercised) in the company would dilute other shareholdings. A cap on the ESS allocation means that shareholders will know how much of the company they will own once all the options or shares have been fully exercised or issued.

Investors will not want the ESS to dilute their shareholding. The best way to achieve this is to have the ESS allocation taken out of the pre-money valuation (this is the value of the company before the investors put in their investment amount). In effect, this means that the existing shareholders — most likely the founders and early stage investors — will accept a dilution to allow for the ESS allocation.

An ESS can, however, make a startup more attractive to investors. It’s a way to reward staff, and by including vesting provisions, employees feel incentivised to contribute to the business for the long haul — increasing the likelihood of ongoing, long-term growth.

How Does the Cap Table Incorporate the ESS?

To help you understand how a cap table includes an ESS, we have set out a simple example below that includes the following key features:

  • the company is raising its first round of capital;
  • the company currently has two shareholders (the founders);
  • the pre-money valuation of the company is $10,000,000;
  • there will be four investors participating in this round, and they are each investing $500,000, meaning a total investment of $2,000,000; so
  • the post-money valuation of the company is $12,000,000.
  • The investors would like the company to have an ESS Option Pool of 10%; and
  • the investors do not want the option pool to come out of their shareholding, so the shareholders will deduct the option pool from the pre-money valuation.
Shareholder No. of Shares Percentage owned (excluding ESOP) Percentage owned (including ESOP)
Founder 1 50,000 38.89% 35%
Founder 2 50,000 38.89% 35%
Investor 1 7,143 5.56% 5%
Investor 2 7,143 5.56% 5%
Investor 3 7,143 5.56% 5%
Investor 4 7,143 5.56% 5%
Total 128,571
ESS (Unallocated) 14,286 N/A 10%
Total (inc. ESS) 142,857 100% 100%

As you can see, although the ESS allocation is a percentage of the post-money valuation, it is deducted from the pre-money valuation. The startup has therefore issued the investors with shares at a share price of $69.9986 rather than $100 to take into account the reduced pre-money valuation.

  • Share price (if we do deduct the ESS from the pre-money valuation): $500,000/7,143 = $69.9986; versus
  • Share price (if we do not deduct the ESS from the pre-money valuation): $10,000,000/100,000 = $100

The investor wants to ensure that the startup doesn’t dilute their shareholding to create an option pool. They want to invest after the founder’s shares are diluted to ensure the potential value of their shares. This is referred to as investing on a fully diluted basis.

The effect of taking an ESS pool out of the pre-money valuation is that shareholders, before all share options are exercised, technically own a higher percentage of the company than they may have ‘agreed’. If the full allocation of share options is never exercised, the shareholders will end up with a higher percentage than they were expecting.

***

Download your free cap table to manage your startup’s equity. The proforma template will allow you to model shares, options and convertible notes. You can also discuss your upcoming capital raise with our startup lawyers on 1300 544 755.

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