New Australian laws in 2015 change the tax treatment of Employee Share Option Plans (ESOPs), making ESOPs usable by Australian startups for the first time since 2009. Basically, the way it used to work was that when you received equity “for free” the market value of that equity could be taxable when you received it. Now, that “free equity” can be taxed when you sell the equity – subject to your ESOP meeting certain conditions. However, the law doesn’t give startups a user-guide on how to create and manage ESOPs that qualify for the favourable tax treatment. From the currently available information, we set out what we can deduce about ESOPs in the context of Australia startup companies  to help you understand more about ESOPs and how you can use them in your startup.

Terminology

• ESOPs are referred to as “Employee Share Schemes” (ESS) under the new Australian law . The term ESOP comes from the most commonly used term for such a legal scheme in the USA (employee stock option plan) and most startup literature uses this acronym. It’s important to remember though in Australia we don’t use the term “stock” – we use the term shares.

• Shares are a unit of direct ownership of the company, representing a piece of the total value of the company. For an ESOP, a share will usually be an “ordinary share” (note that Australians have ordinary shares – not common stock).

• Options are a right to be issued shares under certain circumstances (the passing of time, payment of money etc). Options defer the creation of the share until a future time – which means that under an ESOP, options that are issued may actually never result in any shares being issued.

• Securities is the collective term for shares and options.

What is an ESOP for a startup?

What is a compliant, tax effective ESOP?

The primary benefit of the new law is that under certain circumstances a recipient of ESOP securities will qualify for the small startup tax concession. This concession means the recipient will not be taxed on the market value of the securities on the day they receive the security, but instead will only be taxed when they dispose of the security.

To implement a compliant, tax effective ESOP for a startup, you need to have a few qualifying features:

• If your ESOP grants shares as well as options, the ESOP must be available to no less than 75% of employees that have been of service for 3 or more years.
• Any options issued under the ESOP must have an exercise price above the current market valuation of the ESOP securities.
• The company (and all other companies in a group) must not be older than 10 years.
• The group turnover must not exceed $50M per annum in the year the ESOP securities are issued.
• The ESOP must require that ESOP securities are held for no less than 3 years or until the holder ceases employment.
• The company must be an Australian tax resident and cannot be listed on a stock exchange.

In addition, the value of the ESOP securities (and in turn, the company) must be taken into account. Another benefit of the new laws are safe harbour valuation methodologies (valuation formulas that are approved by tax law) that make sensible, practical startup valuations possible. These methodologies acknowledge that despite any investment capital injected into a startup, the value of the company (and in turn, the ESOP securities) is often still closer to nil, given the risk that the company will not succeed. Where there is real value in the company (and in turn, the ESOP securities), to achieve the small startup tax concession and issue “free” securities, it will be necessary that the securities issued have an exercise price above the current valuation (namely options will need to be issued, not shares). If the company has a real value, and/or financial resources, it will be expected to use a comprehensive market valuation methodology to accurately determine the value of an ESOP securities. In this case, should you issue shares under the ESOP, only a small discount to market value will be tolerated.

The tax impact on issuing securities directly, without adopting a formal ESOP, is not dealt with in this post (although the new law makes it possible for the safe harbour valuation methodologies to be approved to apply in that circumstance).

What are the steps to implement an ESOP?

By definition, an ESOP is a “plan” and therefore is a formal written policy of the company, not just an ad-hoc issue of equity.

An ESOP will require:

1. The formal rules of the ESOP, which sets out eligibility and what conditions can be set on ESOP securities, compliant with the requirements of the law.
2. Adoption of the ESOP by the company, usually by a resolution of the directors. Many companies will require shareholder approval to adopt an ESOP under their constitution and/or shareholder agreement.
3. A written offer (normally in the form of a standard letter) to invite participants to take up ESOP securities.
4. Written acceptance of the offer by the participant, which includes being bound by the rules of the ESOP.
5. Issuing the securities to the participant (usually evidenced by a resolution of the directors of the company, providing a certificate of those securities to the participant, updating and company’s registers and updating ASIC).
6. A determination of the value of the ESS securities.

There will be a legal process involved in preparing all the documentation.

Some Critical Considerations for an ESOP

At General Standards, we work with hundreds of startups every year, and implementing an ESOP will have an impact on the overall running of the company, which must be taken into account:

• The whole problem with ESOPs has been “tax treatment”. Getting it wrong will have unexpected tax consequences for participants. Issuing securities under the ESOP is still a formal legal process that must be completed properly. Half-baked implementations are unlikely to be given sympathy by the Australian Tax Office. If the directors of a company represent to the team that their securities will be “tax free” and that is not the case, questions of liability for both the company and directors will be asked.
• The tax effectiveness of the ESOP is dependent on knowing the value of the ESOP securities – this will need to be formulated each time there is a grant of ESOP securities (especially where the company is growing and/or receiving investment).
• If you are receiving investment, using preference shares will be important to make sure that you are not inadvertently increasing the value of the ordinary shares, which need to be valued as low as possible for ESOP purposes. Issuing ordinary shares to investors could potentially make the safe harbour valuation methodologies of no assistance to the company.
• ESOP securities should still have a “risk of forfeiture” requiring that participants need to fulfil agreed obligations in order to own their securities without any risk (these are usually referred to as vesting conditions)
• Changes to employment agreements (and other service agreements) may be necessary to accommodate the ESOP and vesting conditions.
• A low valuation is a good thing when it comes to ESOPs – don’t let your ego get in the way!

Do you need a lawyer or accountant to implement an ESOP?

It is likely that most startups will require assistance implementing an ESOP. Our experience at General Standards, working with hundreds of early stage startups each year, has shown that even simple corporate actions (such as director resolutions) are often not completed properly. Therefore it will be prudent to have a professional assist the directors to setup the ESOP. In addition, many startup directors may wish to obtain formal tax advice before issuing ESOP securities to make sure that their valuation methodologies are sound. On that basis, getting legal and/or accounting advice makes sense, especially while these laws are so fresh.

In the future, it is likely that newly incorporating companies will be able to adopt an ESOP at (or very close to) incorporation, resulting in the ability to use standardised documentation without legal or tax complications. If you’re already in business, and especially if you’re generating revenue or have raised capital,  then there are a lot of variables to consider, and it is unlikely such simplicity will be available to you.

In Conclusion…

The new ESOP laws are a positive step for Australian startups. Like all things, it is easy to consider the negative elements, and these laws are by no means perfect or completely clear (and on that basis, if you think we’ve got something wrong, please let us know). However, they are better than what we’ve had since 2009.

However, you have to take laws in the context of the whole business landscape. Australia still remains a simple and stable jurisdiction to do business; the last budget gives startups great tax relief in the form of more deductions, a soon-to-be-lowered corporate tax rate and these new ESOP laws; we have great programs like the R&D Tax Incentive and Export Market Development Grants – all of which make Australia a wonderful country in which to live as an entrepreneur.

If you’d like to discuss implementing an ESOP with General Standards, we have a number of dedicated free ESOP consultation times available each week (book here). Prices start from $2,000 and include all documentation and the issue of securities to your first 2 participants.

This post does not constitute legal or tax advice, and General Standards recommends you seek the assistance of a lawyer when implementing an ESOP.

General Standards founder Kurt Falkenstein was interviewed by The Australian Women’s Weekly with his startup lawyer tips for investing in startups and small businesses. Also interviewed was Sydney Founder Institute director Benjamin Chong (General Standards is the official Australian legal partner to Founder Institute). The article has great practical tips on how women (and men!) should approach making investments in private companies.

Starting a business can be one of the most rewarding, exciting, and stressful things you ever do. While forming a company with others can often makes a huge amount sense, as each person can bring unique skills and experience to the business, it is certainly not uncommon for issues or differences to arise down the track that founders simply do not foresee at the beginning of their relationship. Fortunately, both New York (NY) and Delaware (DE) law allow businesses to structure their organizational documents so that these issues can be adequately prepared for before they come up. Two of the big ones to keep in mind are:

Transfer of Ownership Interests

Whether you have a corporation, LLC or partnership, there may come a time when one of the founders decides to part ways with the company. When that happens, typically the existing owners will want tight control over who can purchase the ownership interests of the departing individual, and how this process is managed. Your corporate bylaws, LLC operating agreement, or partnership agreement can (and absolutely should) contain provisions that dictate how ownerships interests are transferred.

First, most LLCs (though corporations can also be structured this way) are set up so that all of the remaining Members would have to agree to any transfer of ownership interests. This can be modified so that only majority, or supermajority, consent is needed, but either way this puts some power in the hands of the remaining owners.

Second, you can include a right of first refusal in your bylaws, operating agreement or partnership agreement. A typical right of first refusal provision would require a departing owner to first offer his or her ownership interests to the existing shareholders, Members or partners. If none of the existing owners want to purchase the interests, then the departing owner may find a buyer on the open market. Once a buyer is found, that buyer’s offer would be communicated to the remaining owners who, once again, would be given a chance to purchase the interests at the same price. If the owners again reject the offer, then the departing owner can sell his interests to the third party.

Third, some companies have provisions regarding what happens to an owner’s interests in the event he or she gets divorced. Since most states would treat company ownership as a personal property interest, the founders may want to include language in the bylaws, operating agreement or partnership agreement that specifies that a divorcing member must sell, or that interests passing to the ex-spouse will be purely economic interests (with no voting or management rights), or any other provision that the founders agree upon.

Non-Performance or Under-Performance

In addition to including sections in your bylaws, operating agreement or partnership agreement that specify the procedure to be followed in the event a founder voluntarily wants to leave the company, one situation that is frequently left unaddressed in company documents is what to do in the event a founder fails to perform his or her duties. Without clearly specifying what each founder’s roles and responsibilities are, either in the formation documents or in a separate agreement, it is nearly impossible to involuntarily remove a founder from his or her position. This type of provision would typically specify what relevant the performance measure are involved, and include procedures for voting on performance by the remaining owners and for returning the removed owner’s capital contribution and any profits earned to that point. If you take the time to not only state what each person’s responsibilities are to the company, but also include provisions that permit the founders to reasonably remove a non-performing or under-performing owner, then you will ensure a smoother transition in the event you encounter this type of circumstance.

If you want to learn more about your rights as a co-founder, book an appointment with a General Standards attorney here.