The Australian Tax Office (ATO) improved the way participants are taxed under eligible Employee Share Option Plans (ESOPs) in July 2015. Since then, ESOPs have become increasingly popular. Many of the startups who implemented ESOPs have now grown and are looking at an exit event in the near future. Which poses the question: what happens to the options pool if your startup is acquired?

Defining an ESOP

An ESOP is a scheme to incentivise employees. It involves your startup offering options to purchase shares in the company to its key employees, contractors and/or directors. The options will generally be subject to vesting criteria (for example, a four year vesting period with a one year cliff). The options will also be subject to the employees’ ability to retain and deal with their options over time or in line with performance criteria.

Once the employees’ options have vested, you may give them the right to exercise their options. This would involve converting the employee into a shareholder and the employee paying the relevant exercise price. Alternatively, the employee may only be able to exercise their vested options upon an exit or insolvency event occurring.

The company and its offer must conform with the ATO’s prescribed eligibility criteria in order for the employee to access the tax concessions. The ATO has also created standard documentation, including plan rules and an offer letter. Most startups will structure their ESOP similarly to the ATO’s sample documents.

Your company’s ESOP plan rules and associated offer letter will set out the specific terms and conditions of the ESOP offer, including what happens to the options pool if your startup is acquired.

Treatment Of Outstanding Options At An Exit Event

There are generally three types of exit events contemplated by the ESOP:

  1. a listing;
  2. a business sale; or
  3. a share sale.

If the board of directors are contemplating selling the business (via its assets) or all shareholders are selling to a third party, your company should take the relevant steps set out in the ESOP plan rules. Very often, the board will have discretion under the plan rules to decide how to deal with the employees’ options at the time. This generally involves one of two choices:

  1. Buy-back or cancel some or all of the options in exchange for their fair market value. This includes even those options that have not vested; or
  2. Notify the employee of the number of options that will vest (this can include accelerating the vesting of options which would not have otherwise vested as a result of the vesting criteria). Then, make the relevant arrangements so that the employee can exercise their options on or before the exit event.

If the employee does not take steps to exercise their options, you may also compel them to exercise their vested options by the time of the exit event (or very soon following the exit event, if it was not anticipated). If they do not do this, the employee’s options will lapse and they will receive nothing for these options.

Acquisition by a New Holding Entity

Sometimes, the sale of shares involves shareholders exchanging their shares for new shares in a new holding entity (with the same or a similar ownership structure). This is a reconstruction event. The treatment of option holders is different.

Where there is a reconstruction, the board will again have the discretion to do one of the following things:

  • grant new options in the new company in exchange for the old options;
  • arrange for the new company to acquire some or all of the options in your company for their fair market value;
  • buy-back or cancel the options in exchange for their fair market value; or
  • notify the employees of the number of options that will vest as a result of the reconstruction exit event. Make the relevant arrangements so that the employees can exercise their options on or before the exit event.

If the board gives employees the choice to exercise their options, it must also ensure that it gives the employees’ shares the same rights and benefits as the other shareholders in relation to the exit event. If the employee does not exercise their options in time, they may lapse.

Acquiring Some Shares

If the majority shareholders (usually shareholders holding over 50%) want to sell their shares, they may request that the board issue a drag-along notice to the employees and other shareholders (dragged holders).

Under a drag-along notice, the majority shareholders can force the dragged holders to sell all of their options or shares to the third party purchaser on the same terms (including for the same sale price). The board would compel an employee who had exercised some of their options but not others to sell both their shares and options.

However, under an ATO compliant scheme, employees cannot dispose of their options within three years from the date of issue. The exceptions to this rule are when:

  • there is a takeover;
  • there is a restructure; or
  • the employee leaves the company.

In this case, the majority shareholders could not compel the employee to sell.

Employees Exercising Their Options

Employees will exercise their options by giving the company a signed exercise notice and paying the exercise price. You set out the exercise price in the ESOP offer letter. Under an ATO compliant scheme, your company can set the exercise price using the ATO’s safe harbour valuation methodologies. This means that the exercise price is likely lower than the traditional value of the options at the time they were granted.

If an employee exercises their options, your company must issue them with the number of shares corresponding to the number of options. You then:

  • give them a share certificate for the shares;
  • enter them onto the company’s members register; and
  • update ASIC.

The employee is now a shareholder and will be subject to your company’s shareholders agreement and constitution. They can now participate in an acquisition via the sale of their shares. Alternatively, they can benefit from the proceeds of an asset sale in proportion to their shareholding.

The shareholder must ensure they hold the shares for the minimum holding period (MHP), which is the earlier of:

  • three years from the grant date; or
  • the end of their employment.

This means that the shareholder cannot sell within three years unless they have stopped working for your startup.

Key Takeaways

Different courses of action could happen to the options pool if your startup is acquired. It is therefore important that you review your ESOP plan rules. You should also review each employee’s offer letter to ensure you take the appropriate steps.

An employee will generally either get paid fair market value for their options or will be able to exercise their options and participate directly in the acquisition. They also may find that the board will accelerate the vesting of their options.

If you have any questions about an existing or contemplated ESOP, get in touch with LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.

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