A business can give its employees, contractors and/or directors options to purchase shares in the company. This can be done with an options pool, under an Employee Share Option Plan (ESOP). ESOPs are becoming increasingly popular for startup businesses. This is largely as a result of the 2015 change to the way participants are taxed under the Australian Taxation Office’s (ATO) scheme. This article will set out the ATO scheme and explain how your company can structure its options pool.
The ATO Compliant Scheme
Under an ATO compliant scheme, an employee will receive their options for free and at a low exercise price. This means that they have to pay very little when they convert their options into shares. The employee will not pay tax when they receive their options. They only pay tax once they eventually sell their options or shares.
The options will usually be subject to vesting criteria. This means that the employee must earn them over time. If they leave the business before the vesting is up, they will forfeit their unvested options. A common vesting schedule for options is four years, with a one year cliff. Issuing options subject to vesting helps you retain your key people. It also incentivises those people to help grow the business (and its share price).
Due to the win-win potential of ATO compliant ESOPs, many eligible startup businesses choose to implement them. However, structuring the ESOP’s options pool can often cause confusion.
Options are Not Yet Shares
Options are only a right to shares in the future, they are not shares themselves. This means that they will not show up on the company’s members register and they will not, on their own, dilute other shareholders.
An options holder will not have any right to dividends or the right to vote at shareholders’ meetings. The company will keep a register of options holders but it is not obliged to update the Australian Securities and Investments Commission (ASIC).
Options Pools in Practice
When a company decides on the size of its options pool, it is not setting a certain amount of shares aside. Instead, the company is letting shareholders know that up to a certain percentage of the company may be issued in options at some point in the future.
This gives the existing shareholders a chance to understand and agree to the maximum amount of dilution as a result of the options pool. This dilution does not occur until the options are issued by the company and converted into shares by the options holder.
Size of Your Options Pool
Options pools do not have to be a particular size. The company and its shareholders decide on the size of the pool. However, a pre-agreed options pool allows the company to issue options to participants without the shareholders’ further consent. This means that the shareholders must agree to the size of the pool. As a result, it is generally not overly large.
Most commonly, a company’s options pool will be between 10-20% of the issued share capital of the company at the time of the agreement. If a company wants to increase the size of its options pool in the future, it would likely need all shareholders to agree (or otherwise abide by the company’s shareholders agreement).
Investors and Your Options Pool
If your company is seeking investment and does not already have an options pool, you may be asked by your investor to put one in place. Investors see the value of an options pool for a company.
They like to see that employees are incentivised to make the company a success. However, a sophisticated investor may also want to ensure that their investment is not diluted by the future implementation of the pool. To this end, they will require that your company contemplate the size of the options pool by reference to the valuation of the company prior to their investment.
The company may only have three key staff members now, but that does not mean that each should get one third of the option pool. It is important to plan ahead and contemplate potential expansion when issuing options to employees. There is no golden rule regarding ‘a fair percentage of options’ to issue. However, you should consider:
- the value of the company at the time;
- other remuneration that the employee might be receiving; and
- the value of that employee to the business both now and in the future.
A well-structured ESOP will help align the key people in your business with the goals of the company. It will ensure that the company does not give away too much equity to non-cash investor shareholders. An options pool will also increase the company’s attractiveness for investors.
If you require assistance structuring or implementing an ESOP, contact LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.
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