Employee Share Schemes (ESS)February 2015

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Section 1Introduction

Government has released changes to come into effect once legislation is passed

Employee share schemes – taxation changes

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Section 1Introduction

What is an employee share scheme?

• Non-cash incentives provided to employees

• Widely used in US startups

• Provided in the form of shares or options

• Usually tied to some performance criteria or vesting conditions

• Potential for adverse tax consequences for employees at grant date

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Section 2Cap table structure

Cap table structure

• Angel/VC round investment often stipulates ESS pool

• Notional pool at this stage (ie. 15% ESS pool)

• Pool size reset at each investment stage

o Issued ESS interests will dilute

o Unissued ESS interest will reset

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Section 3Overview of existing rules

Existing tax issues

• Currently the difference between the value of the options and the amount paid (usually nil) is taxable to the employee (referred to as the discount)

• Discount is assessable upfront (at grant) unless it can be demonstrated that there is a real risk of forfeiture (deferral case)

• Under deferral case, employee is taxed at the date the risk of forfeiture ceases (ie. vesting) at the market value at that date

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Section 3Overview of existing rules

Why is this a problem?

• Generally the employee will not have the funds to cover any tax liability upfront (ie. may be many years prior to disposal of the shares)

• High risk nature of startups mean that the ‘value’ of the ESS may never be realised

• Under deferral case, employee is taxed at marginal tax rates based on value at the time. May be significantly higher than at grant and realisation event may still be many years away.

• Difficultly in obtaining market values

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Section 4New rules – all companies

New rules – all companies

• Broader availability of deferred taxing point for options

• Scheme genuinely restricts the employee disposing of rights (options)

• scheme rules expressly state that the scheme is subject to deferred taxation

• Maximum deferral extended from 7 to 15 years

• Commissioner to provide safe harbour valuation techniques

Section 5New rules - startups

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Tax concessions available to startups – what defines a startup?

Structure

Size

Age

• Not listed on ASX or other exchange

• Australian resident company

• Aggregated turnover not exceeding $50m

• Company and related entities in group incorporated for less than 10 years

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Section 5New rules – startups

What it means?

• Discount received on ESS interests (shares or options) is tax free to the employee

• Shares subject to capital gains tax (at sale) with a cost base equal to:

• Shares – market value of share

• Options – amount paid for option (and subsequent share)

• Safe harbour market value techniques prescribed by and binding on the ATO

Section 5New rules - startups

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Requirements

>$50m turnover

Less 10 years old

>10% ownership

Held 3+ years

Shares ->15%

discount

Options –out of the

money

Open to 75%

Unlisted -ordinary shares

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Section 5New rules – startups

Conditions

• Ordinary shares

• Less than 10% voting rights and ownership

• Shares – discount of less than 15% of market value

• Options – exercise price greater than current market value

• Ordinary shares

• Requirement to hold shares/options for a minimum of 3 years

• Scheme available to 75% of employees with 3 or more years service

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Section 6Where to from here?

Worked example

• Startup is owned by two founders with 3500 shares each

• Seed/angel investment round raised of $200,000 @ $800K pre-money valuation

• Term sheet stipulates an option pool of 10%

• Cap table after investment round• Founders 7,000 70%

• Seed investors 2,000 20%

• ESS pool (unissued) 1,000 10%

• Any options that have issued will dilute with further investment

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Section 6Where to from here?

Worked example cont.

• Key sales employee issued with 100 options (ie. 1%)

• Options vest (ie. become exercisable) over a 4 year period as follows:

• 25 options vest after 12 months providing key customer relationship x is established

• next 25 options vest after 24 months providing sales target y is met

• etc etc.

• Exercise period of 4 years from date options vest

• Exercise price of $1.10 per option based on recent funding round

• No upfront tax and eventual sale of shares taxed as capital gain

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Section 6Where to from here?

Where to from here?

• Legislation to pass through Parliament

• ATO to release safe harbour valuation techniques

• Lawyers – cost effective ESS scheme templates

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Cole Wilkinson - PartnerBusiness AdvisoryEmail: cwilkinson@pitcherpartners.com.auPhone: 07 3222 8445