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Since the July 2015 changes to how Employee Share Option Plans (ESOPs) were taxed, many eligible startup employers have been implementing ESOPs with their key employees. Below, we set out what is an ESOP and how they work.

What is an Employee Share Option Plan?

An Employee Share Option Plan (which is also known as an Employee Share Scheme, or ESS) is a scheme where employers offer employees shares or options to acquire shares (an ESS interest) in the company.

Employers usually offer ESOPs to key employees whose dedication and expertise has become fundamental to the business. It is a way of rewarding and retaining key employees. Startups typically have limited capital, and so an ESOP is a good way to show your key employees that you appreciate and value their contribution. If an employee accepts an ESOP, an employer will explain (and subsequently reduce to writing) how many options for shares they will offer, when the shares will vest and the cost of the shares.

How Does an Employee Share Option Plan Work?

Most documentation in respect of ESOPs will cover the following matters:

  • The employer will offer the employee a set number of options to buy shares in the company at a fixed price. This amount is known as the exercise price or the strike price. Options do not carry voting rights or the right to dividends. These rights will be available only if or when the options turn to shares.
  • The options will vest gradually over a set period. What this means is that ownership of the share options will not be given to you immediately but over a length of time.
  • An option cannot be exercised by an employee until it has vested. An employee can’t purchase shares in the company until the options have vested following the time frame set out in the documentation.
  • At the date of giving the options over to an employee, the exercise price of an option must not be for less than the market value of shares in the company. Safe Harbour Valuation Methods determine the market value of the company at any given time. Ideally, before the employee disposes of his or her shares, they would have increased in value as the business’ performance grows.
  • If an employee decides to exercise the purchase option (buys the agreed number of shares at the exercise price), then they will hold shares in the company. As they will now be a shareholder (and no longer an option holder in respect of this exercised, vested shares), they will need to either enter into a Shareholders Agreement or a Deed of Accession. A Deed of Accession confirms that the new shareholders agree to become bound by the company’s existing shareholders agreement.
  • It is not unusual for an employee to lose any unvested options if they leave the company. The company may require the employee to sell any unvested shares to a nominated person (for a fair amount the company determines.)
  • The company cannot dispose of any options or shares within the first three years unless the employee leaves (or in other limited circumstances). Otherwise, the employee may lose the tax concession. Usually, an employee cannot dispose of options until a liquidation event (that is, an IPO, the selling of the business or shares) unless they have the Board’s written approval. The treatment of any share disposal will depend on the terms of the shareholders agreement.
  • If there is a liquidation event, the company may exercise its discretion and decide to buy-back from the employee any vested or unvested options or notify the employee that all of their options have vested. The employee will need to exercise their options (so the share sale can be part of the liquidation event), or if they decided not to exercise the options, the options would lapse or expire.
  • If there is a liquidation event and the majority shareholders decide to sell their shares as part of this event, they can force the employee to sell all of their shares on the same terms as the majority shareholder, provided the employee had held their shares for more than three years from when the options were issued.

Tax Concessions

Before July 2015, an employee who entered into an ESOP had to pay tax at the time they received those shares or options even though, at that time, they had not received any financial benefit of the shares or options. That means the employee was liable to pay tax each time the shares vested even if they did not end up exercising their purchase option to pay for the shares.

Under the new system, employees will now only pay tax on their shares or options when they receive a financial benefit (i.e. when the employee sells the shares).

Key Takeaways

In practice, many employees exercise their options on the same day as a liquidation event takes place and hopefully receive a profit. The changes to the tax treatment of ESOPs have made it more attractive for employees to enter into them with their companies. We see many more companies, particularly startups, opting to enter into ESOP schemes with their key employees to retain their best talent.

If you are interested in taking advantage of the ATO Tax Concessions for Employee Share Option Plans and offering your key employees options in your company, get in touch with our startup lawyers. Likewise, if your employer has spoken to you about implementing an ESOP in your company, you can ask us your questions on 1300 544 755.


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