Startups are about teams. Although your team may begin with one or two founders, you’ll soon bring on board employees. Many successful startups scale quickly, so you need to plan for how you’ll help motivate your team members and ensure they stay with your company.

There are two legal matters concerning employees that almost every startup will need to think about, both covered in this section:

  • employment contracts
  • employee share schemes

Employee or Contractor

When hiring new team members, the first thing you need to consider is whether they are an employee or contractor. Taxation, superannuation and employment law obligations differ for each and this issue can get early stage startup founders into trouble. Some factors that determine whether a worker is a contractor or employee are set out below.

Importantly, you can’t call a worker a contractor while treating them as an employee (also known as ‘sham contracting’). The ATO frowns upon businesses that mischaracterise workers to avoid their employment law obligations. If you are unsure, use the employee/contractor decision tool on the ATO’s website to determine whether your team member is an employee or a contractor.

Decision Tool:

Control: Does the hirer have the right to exercise detailed control over the way work is performed or does the worker have full autonomy?
Separate place of work and advertises services: Is the worker required to wear a uniform or display material that associates them with the hirer’s business?
Provision and maintenance of significant tools and equipment: Is the worker required to supply and maintain any tools or equipment (especially if expensive)?
Right to delegate or subcontract work: Is the worker free to work for others at the same time? Can the worker subcontract the work or delegate work to others?
Income taxation deductions: Is taxation deducted by the hirer from the worker’s pay?
Remuneration: Is the worker paid according to task completion, rather than receiving wages based on time worked?

Intern or Employee

Startups may also host interns looking to obtain work experience. An internship can be a worthwhile learning experience, offering the intern access to mentors and skill development. However, it’s important founders remember that an intern does not replace an employee.

Internship Purpose

Before engaging an intern, ask yourself what is the purpose of the arrangement? Is it to provide a benefit to the individual or the business? If it’s the latter, it’s likely to resemble an employment arrangement. Remember that the primary benefit derived from the internship should flow to the individual. It is a genuine opportunity for him or her to observe and learn. Startups should consider bringing on interns that are required to undertake an internship as part of a vocational placement for TAFE or university. In this way, the intern can provide a greater contribution to the business rather than just observe (for example, during work experience).

Internship Pay

If you bring on an intern, ensure that your internship agreement clearly states that the role is unpaid and for a finite agreed duration. You may choose to offer a stipend to cover lunch and travel expenses. However, payments comparable to wages can point to an employment relationship, for example:

  • Regular payment calculated with reference to time or hours worked
  • Large lump sum payments, or
  • Allowances that far exceed the expenses incurred.

Internship Duration

We commonly speak to startups that misunderstand an internship’s primary function is for the intern to derive benefit through observing and learning from others in the business rather than directly contributing to its productivity. Parties should agree on the internship’s length at the outset (4-12 weeks for example) rather than an indefinite placement.

Consequences for Mischaracterising a Relationship

If a startup founder is found to have engaged interns, but the relationship is in fact employee-employer, they will be liable for back pay and other employee entitlements. The business could also face fines of up to $51,000-$54,000 for each breach of the Fair Work Act. Directors/managers of the business are also exposed to individual fines for breaches of the Fair Work Act.

Employment Contracts

Employees all need employment contracts. It’s remarkable how many founders don’t bother with ensuring their employees have an agreement in the early days. Your employment contracts should address a number of standard issues (intellectual property, restraint of trade, leave requirements, etc.). In the startup space, it’s especially important to include an extended probation period (ideally six months). Startup life isn’t for everyone and a lengthy trial period helps both the startup and team member work out if there’s a good fit.

Tip: If you decided to host any interns, ensure that you have an internship agreement template in place so when he or she starts, you can fill out their role, learning aims and both parties’ obligations together. Avoid the trap of falling into an informal intern arrangement.

Employee Share Schemes

Obviously, you want the best person for the job, in the job. But as a startup (unless you’ve raised plenty of capital), it’s unlikely that can pay top dollar for team members. Enter an Employee Share Scheme (ESS). Under an ESS, you can offer team members shares or options to buy shares in the company. Nearly every high-growth startup will have an ESS. Offering team members shares or options in the startup can help bridge the gap between their startup salary and an equivalent corporate salary. An ESS is also a great way to ensure your employees feel like they have a real ownership stake in the business and that their interests align with your startup. The startup’s success will be their success.

Methodologies

In July 2015, the ATO made changes to how they taxed ESS in startups. If your startup meets certain eligibility criteria, you can issue shares, or options to purchase shares, to an employee who is taxed only when they make a financial gain (usually when they sell their shares). In other words, the ATO will not tax your employee when your startup issues him or her shares or options, when their shares or options vest, or when they exercise their options (if applicable). It doesn’t make sense for employees to pay tax on something that may ultimately prove worthless if the startup goes under.

Once the employee sells his or her shares (generally on an exit event), the gain made will be taxed as a capital gain. If the employee has held the shares or options for longer than one year, he or she will receive a 50% reduction in the capital gains tax he or she must pay.

As previously mentioned, a startup must meet certain eligibility criteria for the tax concessions to apply.

The ATO has issued two safe harbour valuation methodologies which startups can use to value their shares for an ESS. One is essentially a formal valuation, and the other is a net tangible assets test. To use the net tangible assets test, a startup must satisfy certain eligibility criteria. If it meets the criteria, then the startup’s valuation can be calculated using the following formula.  

 

(A – B) / C = Valuation

Where:

  • A means the company’s net tangible assets at that time (disregard any preference shares on issue);
  • B means the return on any preference shares on issue at that time if the shares were redeemed, cancelled or bought back; and
  • C means the total number of outstanding shares (e.g. ordinary shares) in the company.

Startups tend to have few, if any, tangible assets. So, the net tangible assets test enables startups to issue shares or grant options with a share or exercise price that is lower than the share’s market value.

Case Study: Cliff Obrecht, COO of Canva

Incentivising Employees: Issuing Shares in Your Startup

Canva’s recruitment philosophy starts with one fundamental principle – hire the smartest people we can and give them the freedom to manage themselves and determine how they want to work. Our equity scheme is a big part of that philosophy. As Canva continues to grow, we’ve found that giving our team an equity stake in the business has been a powerful way of increasing engagement. Equity makes people feel invested in a business, and that level of investment is crucial in motivating people to do their job to the best of their ability.

If you are thinking about using equity as part of your remuneration framework, you need to be fully aware of your obligations under the Corporations Act. ASIC grants some relief to startups – these include senior manager exemptions and the 20/$2 million rule that allow issuances of up to $2M of equity across 20 employees in a 12-month period – but soon enough you’ll find yourself needing to lodge a public disclosure document. That’s something you should plan for well in advance.

Disclosure Documents

The purpose of a disclosure document is to protect employees (or retail investors) and aid them in making informed investment decisions. There are four disclosure document types, but if you’re issuing less than $10 million of equity, then you’ll probably be lodging an Offer Information Statement (OIS). The OIS must explain the intricacies of the corporate/equity structure and business risks and must attach audited financial statements for a 12-month period including comparatives. Unfortunately, it’s probably fair to say that these obligations haven’t really kept up with the realities of the startup movement, which relies heavily on share option plans to attract and retain talent.

Remember, you only have six months from the end of your financial year to lodge the OIS. This isn’t a long time, particularly if you need to bring the business’ historical financial information in line with prescribed Accounting Standards. It always pays to be prepared, and it’s important that you have a strong finance team with financial reporting experience that are aware of any complex accounting challenges. You should also seek guidance from trusted legal advisors to navigate the Corporations Act requirements.

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This article was an extract from LegalVision’s Startup Manual. Download the free 60-page manual featuring 10 case studies from Australia’s leading VCs and startups.

Lachlan McKnight
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