Finding enough of the right people to invest in your startup is undoubtedly a relief. This is the first step in the investment cycle, but likely the hardest one. Now your attention must turn to a number of considerations, in particular, the tax consequences. The last thing you want is either you or your investor being hit with an unexpected tax bill. This article will discuss when capital raising may trigger adverse tax consequences and how best to structure your capital raises. 

Check Who Legally Owns Your Company

If you are raising money from an investor, you will need to check who legally owns your company. To legally own all or part of a company, you must hold shares in that company. You may think that you and your co-founders own the company, but public records may not reflect this. Often this is because you either: 

  • did not enter into the correct documents when you issued shares;
  • did not enter into the correct documents when you set up the company; or
  • have not notified ASIC about changes to shareholdings. 

Here are some common differences between what founders think and what the public records say: 

What Founders Think  What the Records Show 
“I own my shares through my family trust.” You own your shares in your personal capacity.
“My co-founder and I own the company 50:50.” Only one of you is a shareholder in the company.
“I own 75% of my company, and my co-founder owns 25%.”  There is only one share on issue, and one of you hold it.

If there are any differences between who legally owns your company, and who you think owns your company, this is an issue. This issue must be solved before you can raise money from investors. If possible, you should resolve this issue well before you begin the raise. You may need to transfer existing shares between shareholders or issue new shares using the correct legal processes. Completing these steps may have tax consequences. The closer you get to the raise, the more significant the possible tax consequences. 

Transferring Shares

As discussed above, the shares in your company may not be held by the people you thought held them. If this is the case, you may need to transfer those shares to the correct person. The transferee of the shares (i.e. the person receiving the shares) should ideally pay you or the relevant transferor market value for the shares.

The transferor will then be taxed on the amount it is deemed to have received. This is regardless of the amount actually received. That is, even if the transferor did not actually receive that amount, they will still be charged the amount they are deemed to have received. This is because even if the transferor receives less than market value for the shares, the ATO may still deem the transferor to have received market value for those shares (and therefore tax them on this market value). 

For example: 

  1. you hold 100 shares in your company with a current market value of $1 each ($100 total);
  2. you transfer those shares to your family trust. Your family trust trustee pays you $90 for the shares; and 
  3. even though you only received $90, you will be deemed to have received $100 for transfer of those shares as this is market value. 

If your company has a low market value, you can transfer at this low market value. The difficulty for many startups is determining what its market value is. If your company is not making any money and does not have many assets, you may be able to justify a low value. However, if you are bringing on external investors, your company’s value will go up. This causes problems for any share transfers you make just before raising money from external investors. It suggests that the market value may not have been as low as you stated when you did the share transfer. 

How Do I Know if I Am Selling My Shares at Market Value?

The best way to approach calculating what the market value for your shares is to think about it from the ATO’s perspective.

Let’s say you are successful enough to raise money at a value which is ten times the current share price. One week, you’re transferring shares at a market value of $1 per share. The next week an external investor values your company at $10 per share. This will raise questions as to whether your company is really worth only $1 per share the week before.

You will need to be prepared to explain to the ATO how you arrived at the significantly lower market value for the share transfer carried out just before your capital raise. If you are unable to convince the ATO, the ATO may decide that the actual market value of your shares at the time of the share transfer should be the price paid by your external investors. This can be a huge problem depending on what your external investor valued your company at. If your external investors paid a price of $10 per share, but you transferred 100 shares at $1 per share, then you may be taxed on an extra $900. This is even if you have not received that $900 for the shares. 

In these circumstances, it is best to get an independent valuer to value your company just before you transfer. That way, if the ATO starts asking questions about how you came to the lower valuation, you can point to that independent valuer report. This assumes that the low valuation reflects the market value at the time. You can perform your own calculations to value the shares but this may be riskier depending on your expertise. 

Issuing Securities at Different Prices at the Same Time

Before raising money from investors, you may want to issue you and your co-founders with more shares. You may also be thinking of issuing shares to other people who have contributed to your business, including advisors, employees and contractors. It is important to be aware that the same tax consequences for share transfers apply to share issuances. If you are issuing shares, you need to issue them at market value. Otherwise, there may be adverse tax consequences. 

If you are about to raise money from external investors, your company’s market value is about to increase. If you issue shares to some people for a low or nominal value just before issuing shares to external investors at a much higher price, this may cause tax issues. Similar to the share transfer example, the ATO will question how the market value of your company could have been so low at one point, and then suddenly so high. 

One option is to get an independent valuer to value your company just before you issue any shares. That way, if the ATO starts asking questions about how you came to the lower valuation, you can point to that independent valuer report. 

Issuing Shares to Directors, Employees or Contractors

If you are issuing shares to directors, employees or contractors to the business, an alternative is to issue them with shares or options to purchase shares under an employee share scheme. If certain eligibility criteria are met, the individual receiving the options or shares will receive tax concessions. Options can be far more tax effective than shares if you qualify for the relevant concessions.

First, you can grant the options for no upfront cost. Secondly, the exercise price for the options may be determined using one of the ATO’s valuation methods. The exercise price is the price to acquire a share under the option. One of these is a net tangible assets test. To use the net tangible assets test, you must satisfy certain eligibility criteria. As most startups have few tangible assets, the net tangible assets test should allow your startup to grant options at a nominal exercise price without any adverse tax consequences. This is regardless of whether you are issuing shares to investors at a higher value.

Key Takeaways

Raising capital for your startup is an exciting process. However, there are a few key considerations you should keep in mind before the raise. You should ensure that you: 

  • and any others legally own the company in the way you think you do, with the right people having the right shareholdings;
  • complete any share transfers or share issuances you may need to complete before your raise at market value;
  • have evidence of how you calculated the market value for any share transfers or share issuances you will complete close to the raise; and
  • have considered the use of an employee share scheme if you want to issue shares for low or nominal value to staff.

If you have any questions about the capital raising process, get in touch with LegalVision’s capital raising lawyers on 1300 544 755 or fill out the form on this page. 

About LegalVision: LegalVision is a tech-driven, full-service commercial law firm that uses technology to deliver a faster, better quality and more cost-effective client experience.

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