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In July 2015, the Australian government introduced startup tax concessions for employees being offered shares or options under an Employee Share Scheme (ESS) or Employee Option Scheme (EOS). Under these tax incentives, eligible startups can offer their employees, contractors or directors an ownership stake in the company on tax favourable terms. Accordingly, ESSs and EOSs are a great way to attract, retain and incentivise key talent in circumstances where the company may not be able to offer a competitive salary.
So, what are the key differences between these two plans, and which is most appropriate? This article will explain the differences and assist you in determining which scheme is best suited for your business.
Benefits of Share and Option Schemes
An employee share scheme (ESS) is a plan to issue shares with voting and dividend rights to employees. An employee option scheme (EOS) or employee share option plan (ESOP) is a plan to issue options with no voting and dividend rights, which can one day be exercised or converted into shares.
ESOPs and ESSs incentivise employees by aligning their interests with those of the company. By giving employees a sense of ownership over the company, team members are more likely to band together with the common goal of seeing the company develop and prosper. Overall, these schemes provide a tax-effective way to drive growth in startups and more established businesses.
ESS vs EOS
Employee Share Scheme
Under an ESS, a company will issue an eligible participant with shares upfront. These shares are subject to certain vesting requirements. For example, time-based vesting is common, meaning that if the participant ceases to be employed with the company before all of their shares have vested, the company can buy back or transfer any unvested shares for a nominal price. This has the benefit of motivating employees to stay on board and contribute to the company’s growth for a set period of time.
To be eligible for the ATO startup tax concessions, the shares offered under the ESS must be ordinary (and not preference) class shares issued for at least 85% of fair market value. The company must also offer shares under the scheme to at least 75% of its Australian permanent employees who have worked at the business for at least years. A single employee cannot own greater than 10% of the company’s shares.
Employee Option Scheme
Under an EOS or ESOP, a company will grant eligible participants with “options”. An “option” is a contractual right to acquire shares in the company in the future. Options will be subject to certain vesting criteria, and time-based vesting is common to ensure continued service to the company.
To be eligible for the ATO startup tax concessions, the options offered under the ESOP must be for the purchase of ordinary class shares issued for at least fair market value at the time the offer is granted. Likewise, a single employee cannot own more than 10% of the company’s shares (after exercise of all options). The participant must hold the options/shares for the minimum withholding period of three years or until the startup stops employing the employee.
LegalVision’s Employee Share Schemes Guide is a comprehensive handbook for any startup founder or business owner looking to attract and motivate top employees with an Employee Share Scheme.
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Summary of Differences
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ESS |
EOS |
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Participation |
The company must offer shares to at least 75% of its Australian permanent employees who have worked in the company for at least three years. |
The company can offer options to as many or as few participants as it chooses. |
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Treatment of Unvested Securities |
Unvested shares will need to be bought back by the company and cancelled or redistributed. Alternatively, the unvested shares can be transferred to remaining shareholders. This may be administratively burdensome. |
Unvested options fall away and lapse. Unvested options are cancelled for a nominal amount (typically $1). |
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Voting Rights |
Participants are shareholders from day one. This means they have ordinary voting rights and are entitled to attend and vote at general meetings. This may be a disadvantage, as the company will need to obtain more shareholder consent to pass certain decisions. |
Participants are not shareholders until they have earned and exercised their options. Accordingly, they will not have voting rights. This is a benefit of ESOPs, as there are less shareholders to obtain consent from. |
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Dividends |
Participants are shareholders and are entitled to dividends. |
Since participants are not shareholders, they are not entitled to dividends. |
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Employee Engagement |
Participants have shares in the startup from day one. |
Participants are not shareholders from day one. Employees may be less familiar with this type of security and could consider options to be less valuable than equity. |
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Shareholder Limit |
Under the Corporations Act, a proprietary company is limited to 50 non-employee shareholders. A company implementing an ESS may risk exceeding the 50 shareholder limit, especially if employees with shares eventually leave the company. |
Under the Corporations Act, a proprietary company is limited to 50 non-employee shareholders. A company implementing an ESOP may risk exceeding the 50 shareholder limit. To avoid this, the company may make options only exercisable upon an exit event so that participants can only become shareholders when the company is sold. |
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Cost for the Participant |
Participants must pay at least 85% of the fair market value for each share upfront. To keep the share issue price low and make shares affordable, the company may rely on the ATO’s net tangible asset valuation methodology. |
Participants must pay the exercise price for the option, which is the fair market value determined at the time of the offer. However, participants do not need to pay upfront for their options, and will only need to pay upon their exercise. Similarly, to keep the exercise price low, the company may rely on the ATO’s net tangible asset valuation methodology. |
Key Takeaways
As a startup founder, remunerating and incentivising your top talent can be difficult when funds are limited. If offering competitive salaries is difficult, you can offer eligible employees, contractors or directors an ownership stake in the company on tax-favourable terms. These are known as employee share plans and employee share option plans. Understanding the advantages and disadvantages of each is critical to determine which best suits your business’ circumstances.
If you have any questions or need assistance drafting an ESS or EOS, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
An employee share scheme (ESS) is a plan to issue shares with voting and dividend rights to employees.
An employee option scheme (EOS) or employee share option plan (ESOP) is a plan to issue options with no voting and dividend rights, which can one day be exercised or converted into shares.
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