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In March 2022, the government announced reforms to make it easier for businesses to utilise employee share schemes (‘ESS’) and reduce the red tape so that employees at all levels can directly share in the business growth they help to generate. These changes include:

  • amending the disclosure rules, allowing unlisted companies to offer an unlimited number of shares, of an unlimited value, as long as the employee is not charged more than $30,000 a year for them (up from a $5,000 a year cap). Employees will also be able to accrue up to $150,000 over a five year period; and
  • for employee share schemes where there is no payment to participate, independent contractors will receive the same treatment and receive the same regulatory relief as employees and directors who are participants in the scheme.

An employee share scheme (ESS) provides eligible employees with the opportunity to acquire or purchase shares or share options in the company they work for. In Australia, a recipient under an ESS cannot own more than 10% of the company in total.

There is also an option for employees to purchase shares through a share purchase plan (another type of employee share scheme). In these scenarios, shares are often paid for through salary sacrifice over a set period or by using the dividends received from the shares. In some instances, the scheme may allow employees to pay for the shares in full up-front, or through a loan from their employer. 

Additionally, some schemes allow employees to purchase shares at a discounted price. Startups commonly use share schemes as they don’t yet have the capital to pay competitive salaries.

What are the Advantages of an ESS?

An ESS is a good tool for startups to recruit and retain key employees as it can compensate for lower salaries and relieve cash flow pressures. They are also a useful way of aligning employees’ interests with shareholders’ interests and may foster a greater understanding of the company’s direction and inner workings. Also, having a financial interest in the company’s growth can motivate employees and improve productivity, communication and increase workplace cooperation.

There is also the added benefit of the startup tax concession for recipients of qualifying ESS securities. If correctly set up, employees will not be taxed on the shares’ market value on the day they receive them, and will instead be taxed when they dispose of the shares.

What are the Disadvantages of an ESS?

There are also downsides to using an ESS for your startup, starting with the costs associated with establishing and administering the ESS. It can also have an impact on staff morale and retention where the value of the company does not increase. This can also mean the scheme holds less value for them.

It’s worth noting that an ESS scheme can be dilutive meaning as the startup issues more shares, each share owned becomes a smaller percentage of the company. This can impact the value of shares the employees hold and the level of control the majority of shareholders exercise.

What Do I Need to Create an ESS?

An ESS is a formal written policy and requires the following documentation:

  • formal rules that set out eligibility to and conditions in respect of ESS securities. This may include rules specifying the governance details for administering the ESS, applicable vesting conditions, disposal rights and employee obligations;
  • a director(s) or shareholder(s) resolution approving the adoption of the ESS by the company (depending on the provisions of the company constitution or shareholders agreement, as applicable);
  • a written offer inviting participants to take up ESS securities and explaining the obligations imposed on employees who choose to participate in the scheme;
  • written acceptance of the offer from each participant, agreeing to be bound by the rules of the ESS and acknowledging the obligations imposed by the scheme;
  • evidence of issuing the securities to participants. This should include a share certificate for securities, updating the company registers and updating ASIC; and
  • a determination of the value of the ESS securities. You may require professional advice to ensure the valuation methodology employed is sound.

Startups should first seek legal and tax advice before implementing an ESS to ensure it is drafted and set up correctly.

Tax Treatment of an ESS

Under the prior regime, startup employees had to pay income tax upfront at the time they received the shares or options. However, following changes which came into effect on 1 July 2015, employees must only pay tax on their shares when they receive a financial benefit (typically when they sell the shares).

A startup must first meet certain qualifying criteria to receive the tax concessions mentioned above, including:

  • the company must be an Australian resident, must not be listed on any stock exchange and must not have been incorporated for more than ten years;
  • the company’s annual turnover must not exceed $50 million;
  • if the startup provides shares at a discount, the discount must be no more than 15% of the share’s market value when an employee acquires it;
  • employees must hold ESS interests for at least three years; and
  • if the startup grants share options, the exercise price of the option must be at least equal to the fair market value of a share in the company on the date the company grants an option. For example, if a founder wants to grant an employee 10 options, they need to calculate the fair market value of one share (the company’s valuation divided by the number of shares). If the fair market value is $5 for one share, the exercise price of each option must be at least $5.

When Do Employee Shares/Options Vest Under an ESS?

Most ESS’ will state that the shares or share options (as applicable) are subject to vesting conditions. This means that the shares or share options are effectively released either over time or based on performance. If a shareholder/option holder stops working for the company before the shares or share options have vested, then generally any unvested shares or share options will lapse. The shareholder/option holder can, however, retain any vested shares or share options. You can read more about share vesting in our article, ‘Key Provisions of a Shareholders’ Agreement – Vesting Shares‘.

An employee may sell its shares subject to the provisions of the ESS, the company’s constitution and any shareholders agreement. Note that if the employee doesn’t sell the shares within three years of being issued, then the tax concessions will not apply.

Key Takeaways

Employee share schemes are a good tool for attracting and retaining employees, as well as fostering an understanding of the company and encouraging loyalty and productivity. They are also an excellent means for startups to manage cash flow pressures. It is essential when implementing an ESS to ensure the tax concessions for employees will apply, and that the structure and legal documentation are correct. If you have any questions or would like assistance setting up an ESS for your startup, get in touch with our startup lawyers on 1300 544 755.


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