Perhaps you work in a startup company, and your employer has asked you if you would be interested in participating in an Employee Share Option Plan (ESOP). Or, maybe you are a startup founder looking at alternative ways to reward your key employees. An ESOP provides a means for startup companies to offer shares or options to acquire shares (known as an ESS interest) to employees.
In July 2015, the tax treatment of ESOPs changed to make them more attractive to employees. For this reason, there has been an increase in employers offering ESOP schemes. Whether you are an employee or employer, we’ve set out five key elements you should look for in an ESOP.
Under the terms of an ESOP, an employer will offer an employee options to buy shares in a company. An option is a right (but not an obligation) to purchase shares in a company. An option is therefore not a share. An option will delay the creation of a share until a future date, provided certain conditions have been satisfied. It is, therefore, possible that options may actually not result in any shares being issued.
Options are considered vested when the employee has the right to purchase shares. This means that the ownership of the shares will not be immediate but will happen over a scheduled period of time. The common time frame is between three to five years with options vesting at various intervals during this time.
For example, imagine the vesting schedule was as follows: 25% of the options to vest at the end of the first year, a further 25% at the end of the second year, another 25% at the end of the third year and the final 25% at the end of the fourth year. In this example, by the end of the second year, 50% of the options would have vested (meaning the employee could exercise their options to purchase shares, and if they did so they would be a shareholder). The other 50% of the options would be considered “unvested” – that is, they are not yet able to be purchased as shares.
3. Exercise Price
The ESOP documentation will also set out the price that the employee will need to pay to exercise its option to buy shares. The price to be paid for each share is known as the exercise price or the strike price.
To benefit from the tax concessions, the exercise price that the employee will pay to exercise the option should closely follow the market value of a share in the company on the date the option is offered. If the price does not reflect market value, then the tax concessions may not apply.
A company’s market value is calculated through the Safe Harbour Valuation Method. Buying shares is always a risk. However, every shareholder hopes that as the company grows, the value of the shares in a company will also grow. Under an ESOP, an employee will still have the option to buy shares at the exercise price – hopefully making a nice profit when they decide to see the shares. It is important to note that while the employee has options (and not shares), they do not have voting rights or the right to dividends. These benefits are only available to an option holder once they are a shareholder in the company.
The documents will also provide for how to deal with disposals of options and shares and in what circumstances options and shares will be disposed of. Unless the employee leaves the company or in other restricted circumstances, the employee will need to hold the shares for at least three years to benefit from the tax concessions. Outside of this, employees do not normally dispose of their options or shares unless there is an IPO, the company is sold, or a large number of shares are sold. When an option holder exercises their purchase option and purchases shares, they will need to either enter into a shareholders agreement or sign a deed of accession so that they are bound by the terms of the shareholders agreement. Once the option holder becomes a shareholder, then any disposal of shares will be governed by the terms of the shareholders agreement.
5. Eligible Criteria
One important element concerning ESOPs is whether or not the company is eligible for the tax concessions. To receive the tax concessions, there are certain criteria that need to be met, including:
- The company must be an Australian company, with at least one director that is an Australian resident;
- The company must not be listed on a stock exchange;
- The company must not have been incorporated for more ten years;
- The aggregate annual turnover must be less than $50 million;
- As already mentioned, the exercise price must not be less than market value and should reflect the market value of shares in the company as at the date the options were granted;
- The employee must hold the options or shares for at least three years; and
- Employees cannot hold more than 10% of a company.
There are, of course, other elements that are important when considering the implementation of an ESOP, including the terms of the shareholders agreement. If you have received ESOP documents from your employer and have any questions about how an ESOP operates, or if you are an employer and thinking of giving certain key employees in your company the rights to options or shares in your company, ask our startup lawyers on 1300 544 755.