Employee Incentive Schemes - Start-Ups

A great number of the successful tech companies of this generation have had the same story following their IPO – “early staff of X become millionaires after listing”. And honestly, it is great to see.These staff took a gamble on something that at that stage was probably not much more than an idea in the founder’s head. They also most likely sacrificed some cash salary in exchange for these shares/options. Due to taking on these risks, they struck gold many years down the track.

(Granted, not all start-ups end up this way. But this post aims to be Good Vibes Only).

When executed correctly, an employee share or option plan (ESOP) is a great way to provide non-cash incentives to employees, which can align the financial upside of both the employee and the business in a tax-effective manner.

Where a company can satisfy the start-up concessions available under the tax legislation, it can be a very lucrative end-result.

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n some cases, there can be potentially zero tax to pay upon issuing of the options (especially when the start-up hasn’t yet made tangible profits), with any potential gain after being issued the options being taxed on capital account from that time (resulting in the 50% general CGT discount being potentially available from Day 1).  

What is sometimes forgotten however, is that if the plan was executed ineffectively, the tax sniper in the tower can rear their ugly head after hiding for many years in the shadows.

This is best explained by the following example:

1)     Start-up considers implementing ESOP to key staff.

2)     Start-up engages their incumbent accountant and lawyer (who may not be experts in the ESOP space) to provide tax advice and draft the legal documentation.

3)     Many years pass and it becomes time (or it becomes mandatory) to exercise the options (usually by way of a sale event or IPO).

4)     Employee realises that due to the ESOP not perfectly aligning with the requirements at the time of issue (especially in the case for the concessional start-up rules), the ATO comes at them for much more than they originally anticipated.

A not uncommon example relates to ESOPs being issued to family trusts controlled by employees. In the regular ESS tax world, this is a very common scenario and can be a beneficial way to hold a long-term capital asset. In the start-up ESOP tax world, however, this can be a very nasty result.

One example is an employee who, the day before IPO day, exercises their options (held in the family trust) into shares, and then sells the shares the following day. Due to the way the CGT provisions work, the family trust doesn’t get the 50% general CGT discount from the date they acquired the underlying options, whereas if held directly by the employee, they would. It’s not an equitable outcome, but what makes logical sense doesn’t always align with our income tax legislation.

But it keeps me in a job.

Another potential (and real-life) horror story is where a company assumes that they satisfy the requirements under the start-up concessions and rely on the concessional valuation method of “net tangible assets” to value their options and calculate the exercise price.

In some cases, there can be potentially zero tax to pay upon issuing of the options (especially when the start-up hasn’t yet made tangible profits), with any potential gain after being issued the options being taxed on capital account from that time (resulting in the 50% general CGT discount being potentially available from Day 1).  

ESOPs are hard – especially so when you haven’t been exposed to many before. Furthermore, like all small business concessions in the tax legislation, the rules and requirements to obtain this relief are extremely complex.  

Most tech start-ups founders do not have the time (or the willingness – let’s face it, tax can be boring) to verse themselves in tax and corporate law to ensure their ESOP ticks all the relevant boxes. They will have the general idea of how much equity they are willing to part with, and what restrictions they want on vesting (and exercise if options) of these ESOP interests.

Or, they’ll see how stock plans are structured for NASDAQ listed companies and just assume it works the same for their Australian start-up. Spoiler alert – it usually doesn’t. This is where getting good advice is crucial, to ensure that what the founder wants for their staff, aligns with the relevant requirements under the legislation at that time.

As such, it is vital that a start-up engages with their accountant, tax advisor and legal team (and you really need all three working together), to ensure that the implementation of their employee incentive scheme is guiding them one step further towards creating the next Millionaire’s Factory.*

*Pls don’t sue me MQG