The Australian government in July 2015 introduced new tax concessions for startups looking to attract and incentivise key personnel by issuing shares or share options. Resultantly, many startups are now implementing employee share schemes (ESS) whereas previously they may have used phantom shares schemes (PSS) – so what’s the difference? We explain their key features as well as the advantages and disadvantages of implementing an employee share scheme over a phantom share scheme.
What is a Phantom Share Scheme?
A PSS creates a contractual right for an employee to be paid a certain amount of cash (not an issue of shares or options), generally on a recurring basis (e.g. monthly, quarterly or annually), based on agreed company metrics. For example, it may be agreed that there will be an incremental increase in cash payments based on the company’s share price or value. The idea is that the employee will be motivated to perform better to receive a higher cash payment.
What is an Employee Share Scheme?
An employee share scheme creates a contractual right for an employee (or contractor) to receive a certain number of shares or share options at a certain price. The shares or share options vest over a period or based on performance, thus incentivising the employee to remain with the company or meet performance-based KPIs. If the ESS meets the relevant eligibility criteria, then it will attract beneficial tax treatment.
Advantages of an Employee Share Scheme
The benefits of an ESS compared to a PSS arise from the key distinguishing features of each. In particular, PSS are cash payments, as opposed to options or shares in a company.
Cash payments require the company to hold an adequate amount of cash reserves which affects the amount of available working capital. Options or shares also mean participants become a shareholder with a personal stake in the company.
Cash payments are also likely to be taxed as income. Under an eligible employee share scheme, the participant should not have to pay any tax concerning the options/shares it receives under the scheme until it disposes of those options/shares (assuming of course that all the eligibility criteria are met, and the tax concessions apply).
This means ESS present the following advantages over a PSS:
- Liquidity advantage;
- Loyalty advantage; and
- Tax advantage.
Disadvantages of an Employee Share Scheme
One possible disadvantage of an ESS is that there are various eligibility criteria which the company, the plan and the participant must meet to be eligible for the tax concessions – failure to comply with the requirements in full will result in the tax concessions not applying.
Assuming your startup meets the relevant eligibility criteria, then implementing an ESS can be very beneficial when looking to attract and incentivise key personnel. Indeed the benefits appear to outnumber the benefits associated with introducing a PSS. This is why so many startups are doing it and why many venture capitalists require it as a pre-condition to investing. Setting up an ESS is a great way to employ and retain great employees and contractors if you cannot afford to pay competitive wages at this stage.
If you have any questions about the differences between a PSS and an ESS, get in touch with our startup lawyers on 1300 544 755.