Skilled and driven team members are key to making any startup successful. However, startups often have limited funds. So, how do you attract and retain great employees when you can’t afford to pay workers at your startup with competitive salary packages? Many startup owners introduce sweat equity as a way of attracting and incentivising great team members. This article will explain what sweat equity is so you can decide if it is the right choice for your startup business.

What is Sweat Equity?

Sweat equity refers to an arrangement between a business and workers where the worker will provide labour in return for equity. This usually means that the worker receives a lower salary than what they would typically expect in exchange for shares over time.

From the startup’s perspective, it can reduce the cost of remunerating workers until the business has grown enough to pay higher salaries. The worker is also incentivised to work hard. This increases the company’s value and the value of the employees’ shares.

From the workers’ perspective, they forgo remuneration in the short term for the benefit of owning shares which they hope will increase in value. Therefore, they may end up earning more money in the long term than what they would have received with a competitive salary.

Legal Obligations for Employers

It is important for startup founders to understand how sweat equity impacts a businesses’ legal obligations to their employees. If the worker is employed, then the startup is required to pay its employees minimum wage. The startup will need to consider:

  1. if the worker is an employee;
  2. the worker’s minimum award; and
  3. anything else that is legally entitled to the employee. 

The startup cannot avoid these obligations.

Equity Options

In addition to remunerating key team members, a startup may choose to offer them equity. There are three main equity schemes that could incentivise your key team members.

1. Employee Share Scheme (ESS)

Under an ESS, team members buy shares in the company. Under an ESS, the Australian Tax Office (ATO) offers tax concessions to companies and employees. An eligible company that chooses to use an ESS must comply with specific rules which prescribe that:

  • workers must pay at least 85% of ordinary market value unless the safe harbour valuation applies;
  • the shares must be ordinary shares;
  • the shares must vest for at least three years;
  • workers can hold no more than 10% of shares; and
  • the company must offer shares to 75% of its Australian residence permanent employees who have completed at least three years’ service.

These conditions can be restrictive for many startups, especially where they intend to issue shares to only a couple of key workers. Furthermore, the company must undertake a selective buy-back if vesting conditions are not fulfilled. This can be a complicated process to undertake.

2. Employee Share Option Plan (ESOP)

Under an ESOP, team members have the right to buy company shares at a point in the future. After this option is issued, the purchase price and vesting conditions are determined. Like an ESS, an eligible ESOP is a type of equity incentive with particular tax advantages that require compliance with specific rules. These rules prescribe that:

  • workers must pay at ordinary market value unless the safe harbour valuation applies;
  • the shares must be ordinary shares;
  • the shares must vest for at least three years; and
  • workers can hold no more than 10% of shares.

If any vesting conditions are not met, employees cannot exercise their options.

3. Shares Subject to Vesting

A team member may also be issued with non-ESS or ESOP shares. This option is often used where the company intends to issue more than 10% of shares to a team member. It is best practice for shares to be subject to vesting terms.

Vesting is a contractual agreement between a company and a key team member. Shares typically vest over four years. However, shareholders who leave before the end of the first year have automatically offered their shares back to the company. The company may buy back the shares, and the team member will leave without any shares.

Shareholders who leave after a year retain 25% of ownership over the shares they initially purchased. The employee’s ownership of the shares increases each year until 100% of shares have vested over four years.

Key Takeaways

Many startups consider equity incentives for key team members, but few are aware of the different options and their tax implications. Before issuing shares or options, we recommend understanding the best solution for your company and your employees. Different equity schemes you may wish to consider include:

  • ESS;
  • ESOP; and
  • vesting.

If you have any questions, contact LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.

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