Employee share options (also known as employee stock options in the USA and other overseas locations) are a particularly useful tool for attracting and retaining top talent when used correctly. Offering an employee share option plan as part of a hiring package can have a long-lasting effect on staff motivation and retention. However, these plans aren’t something to be taken lightly. Due to their complex nature, an effective and risk-mitigated employee share option plan should always be drawn up by a legal professional. If poorly executed, there are risks. If executed well, a share option plan can pay off for both employees and company founders.
What are employee share options?
In straightforward terms, employee share options are a type of equity often offered to employees or potential employees. This is quite common in startups as well as the tech industry. For workers, employee share options – also referred to as employee share schemes – have potentially substantial financial upsides if the company performs well. For employers, this draw can significantly impact staff motivation, which will ultimately affect the company’s bottom line in a positive manner.
So, let’s look at how employee share schemes work. Generally speaking, what is an employment share option scheme? There are two main types we’ll look at today: Employee Share Schemes (ESS) and Employee Share Option Plans (ESOP). Both of these structures offer employees the opportunity to own a specific number of shares, at a specific price, after a specific period of time.
Take Katie. She’s just been hired at The Good Candle Co., and her employment contract offers a generous 20,000 share options, vesting over two years. The exercise price (being the price payable to exercise the option)) is $12 per share, and with the 2-year vesting schedule, she can choose to buy 10,000 options each year.
If Katie quits before the 2 years are up, she won’t be able to exercise all of her options. Also, this is also only a good deal if the company share price rises – Katie won’t gain any benefits if the share prices fall below $12/share.
Startup concessions and the difference between ESS and ESOPs
In Australia, you’ll often hear the terms ESS or ESOP used interchangeably because these two types of share schemes are very similar. However, there are some key differences – mainly in when a company is required to offer the scheme and to whom.
Before we explain those differences, it’s important to clarify which set of rules startups usually rely on when choosing ESS or ESOP. From July 2015 onwards, the ATO has offered a set of tax concessions for eligible startups with an ESS offering for their employees. Under this scheme, ESS participants only pay tax on the share when they sell it (not when they receive options when options/shares vest or when exercising options). This is called the Startup Concession Scheme. To qualify, the company must:
- Not be listed on the ASX or any other stock exchange (the company must be private).
- Not be older than ten years. The company must have been incorporated less than 10 years prior to the most recent income year.
- Not have returned more than an aggregated turnover of $50 million in the latest income year.
- Be an Australian resident – specifically, the employer company must be Australian.
- Operate a business that does not primarily profit from holding, selling, or buying investments, including securities and shares.
Depending on whether your company sets up an ESS or ESOP, there are additional requirements. Let’s take a look at each type of scheme and its parameters.
- What is an employee share scheme (ESS)?
Employee share schemes, or an ESS, offer employees shares in the company at a reduced rate, and the shares vest over a particular time period. The ATO also confirms that “in most cases, employees will be eligible for special tax treatment (known as tax concessions),” making an ESS plan an appealing benefit for staff.
Employees must have acquired their shares under the scheme while they were actively employed by the company. The shares can only be ordinary shares, issued at 85% or more of current market value at that point in time. In addition, a single employee cannot own greater than 10% of the company’s shares or more than 10% of the voting rights at the company’s general meetings.
- What is an employee share ownership plan (ESOP)?
An employee share option plan, or ESOP, works in much the same way as an ESS. Employees are offered the option to purchase shares at a market rate once the options have vested. However, it’s worth noting that there are no participation or other requirements for an ESOP if your company is a startup. In contrast, if you’re offering an ESS not covered by the Startup Concession Scheme, your company may be required to offer shares to a defined percentage of permanent employees.
Employees must have acquired their shares under the scheme while they were actively employed by the company. While an ESS defines the share prices at 85% or more of market value at that point in time, an ESOP requires that the exercise price be at least the ‘fair market value’ of a share on the date when options are granted. In addition, a single employee cannot own greater than 10% of the company’s shares or more than 10% of the voting rights at the company’s general meetings.
If your company is worried about setting the ‘fair market price’, you should be aware of the ATO’s ‘Safe Harbour Valuation Method’ – if a startup uses one of the two ATO approved methods (being a director’s valuation or a net tangible assets valuation), the ATO will accept the valuation, giving the startup significant and important flexibility on their ability to set a fair market value for their shares, and set up an attractive ESOP for staff.
Is an ESOP or ESS beneficial for employees?
If you’re still wondering if employee share schemes are worth it, it’s certainly worth discussing this in detail with a legal professional. Your lawyer can provide you with a better picture of how issuing share options or offering an ESOP or ESS to employees could impact your business in the immediate and the future.
From a talent management perspective, offering an ESS or ESOP, or some sort of employee share option plan is an excellent way to attract top talent and ensure your employees are aligned with the business and its goals. Offering an ESS or ESOP also incentivises your employees to grow the business, considering the success of the business becomes profitable for them on an individual level. Having an attractive employee share scheme can help you retain key employees. From a cash flow perspective, this setup offers significant benefits at a low cost to the business, so that’s something worth adding to the equation as you make a decision.
What’s the best practice for establishing an ESS or ESOP?
If you’re considering taking this route, you may be asking yourself, “how do I offer performance-based share options for my employees?” or “at what point do companies offer share options?” The short answer-and the safest option is to hire a lawyer. Setting up an ESS or ESOP should never be a DIY project; the risks are far too high.
Our lawyers are experts in ESSs, having drafted schemes for many high-growth startups and businesses across Australia. We can advise on when to bring an ESS or ESOP into play, best-practice for establishing an ESS or ESOP and subsequent vesting schedules, and how to draft all requisite documents, including option plans and letters.
Other considerations should include establishing leaver mechanics to allow flexibility in cases of termination or resignation and establishing drag-along rights (so that if the business sells, the majority can force the minority to sell at the same price).
What are the risks of an ESS or ESOP arrangement?
It’s crucial to protect your company’s interests when setting up an ESS or ESOP arrangement. If done incorrectly, an ESS or ESOP plan can result in problems such as:
- Underperforming or leaving employees still holding equity
- Employees being able to stop a sale or exit of the company for the founders
- High buyback fees
- Disputes and claims by employees
Offering your employees share options can be a great way to attract and retain top talent, especially if you’re a startup with budget constraints. However, setting up the terms of your ESS or ESOP can be fraught. A company should not enter into an ESS or ESOP agreement with employees before obtaining legal advice and review of any agreement.
UX Law provides tailored employee share schemes to incentivise your hires while ensuring that your company’s best interests are protected.