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A premium priced option plan is a great way to incentivise key employees as an alternative to a startup Employee Share Scheme or Employee Share Option Plan. Under a premium priced option plan, a company issues the right to purchase shares:

  • at a future point in time; 
  • at a specified exercise price; and 
  • subject to vesting conditions. 

The key advantage of a premium-priced option plan is its valuation. Whereas the general rule requires employees to purchase shares at market value, premium-priced option plans offer an alternative valuation methodology. This article explains how a premium priced option plan works in practice.

What Is an Option?

An option is the right to purchase shares at a future point in time. Key terms in an option agreement are that option holders: 

  • can purchase shares at the exercise or strike price (which the company decides when issuing the option)
  • can exercise their option during the exercise period only. The period commences when the vesting conditions have been met; 
  • must fulfil predetermined vesting conditions to purchase shares. These vesting conditions are often time-based. The standard is four years with a one year cliff, which means that option holders have the right to purchase 25% of shares after one year, and 1/36th of the balance every month thereafter.

If optionholders never fulfil their vesting conditions, they will never be able to exercise their right to subscribe for shares. Likewise, the options can simply be cancelled. This can often be simpler than issuing shares subject to vesting and buying back unvested shares.

What Is a Premium-Priced Option Plan?

As a general rule, employees (and any other incoming shareholder) should buy shares at fair market value. Otherwise, employees may be taxed on any discount to the market value they receive. The discount (fair market value less the price paid) forms part of their taxable income subject to the applicable marginal income tax rate. In employee equity incentives, the discount can often be significant, and thus, employees’ taxable income is significantly inflated.

However, a premium priced option plan presents alternative ways to value options and varies the amount employees would be taxed. Employees can get tax benefits (that is, rely on the valuation method outlined below to assess the taxable income) if: 

  • the options are unlisted; 
  • the options are exercised within 15 years of their issue.

Although, if any optionholder holds more options over more than 10% of the shares in the company, deferred taxation is not available in any event.

Calculating the Taxable Amount

The method to calculate the taxable amount is a three-step process.

1. Consider the Calculation Percentage

You can determine this percentage by dividing the market value of the underlying share by the exercise price and multiplying this amount by 100.

2. Consider the Relevant Percentages

If the calculation percentage (under Step 1) is:

  • less than 50%, the value of the option is nil;
  • equal to, or greater than 50% but less than 110%, consider the percentages in Table 1;
  • equal to, or greater than 110%, consider the percentage set out in Table 2.

3. Calculate the Taxable Amount

Calculate the value of the right by multiplying the percentage in Table 1 or 2 by the exercise price.

A Working Example

Company A is valued at $400,000 and has 100,000 shares on issue, i.e. each share’s market value is $4. Accordingly, Company A chooses to issue 5,000 options to a key employee – Sam – with an exercise price of $5.75 per share and subject to a vesting period of 4 years, i.e. 48 months. 

Company A and Sam agree to use the alternative valuation:

Step 1: The calculation percentage is $4 / $5.75 x 100 = 69.6.

Step 2: Table 1 is relevant because 69.6% is greater than 50% but less than 100%, and the relevant  exercise period is 48 months. On that basis, the relevant percentage is 0%.

Step 3: On that basis, the value of the right is $0, determined as 0% multiplied by the exercise price of $5.75.

Where the value of the option based on this method is $0, the employee will be taxed on $0 at the marginal income tax.

Likewise, Company A and Sam can play with the exercise price and the vesting period. Doing so will create a different value of the option and, therefore, a different tax outcome. Sam may pay less to exercise the option but pay more tax and vice versa.

Key Takeaways

A premium priced option plan can partially resolve the often unintended outcome of creating a significant tax bill for the employee by electing to be subject to the alternate valuation. By varying the terms of the option arrangement (the vesting period and the exercise price), the parties can come to a manageable and predictable outcome. If you have any questions about your eligibility or need assistance with preparing your premium priced option plan, contact LegalVision’s taxation lawyers on 1300 544 755 or fill out the form on this page.

Frequently Asked Questions

What is a premium priced option plan?

A premium priced option plan is a way to incentivise key employees. Under this option plan, a company issues the right to purchase shares at a future point in time, at a specified exercise price and subject to vesting conditions. Instead of requiring employees to purchase shares at market value, premium-priced option plans offer an alternative valuation methodology.

What is an employee share scheme (ESS)?

An ESS provides a means for startups to offer shares to their employees or options to purchase shares. Under the terms of an ESS, an employer will offer an employee the option to buy shares in a company. An option is a right, but not an obligation, to purchase shares in a company.

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