14 November 2016

Now’s a good time for startups looking at Employee Share Schemes

Now is a good time for startups to consider employee share schemes, given most will have finalised their 2016 accounts and can use those accounts to value their companies under the ATO’s new ‘safe harbour’ valuation method. Last year may have been too soon for some startups to take advantage of the new employee share scheme rules for startups. But with a full financial year under the new regime behind us, the potential pitfalls and how to avoid them are now better understood.

There is no doubt the new regime, introduced 1 July 2015, has led to a re-invigoration of employee share schemes for startups.

The main points from the new regime include:

  • Employees are now taxed at Capital Gains Tax (CGT) rates rather than income tax rates
  • Taxing point deferred until disposal of the equity (no longer any separate taxing point on vesting or exercise)

But the concession is subject to stringent guidelines, including some hurdles around defining a startup in the first place.

Under the rules, startups must be unlisted, have been incorporated for less than 10 years and have ‘aggregated turnover’ – for the most recently completed year – of less than A$50 million.

We’ve now been through the exercise with many startups, and have noticed some major trips and traps which startups need to be aware of.

To date, there has been mixed use among startups. A lot have taken it up, but some have taken a wait and see approach. Loan funded plans, which are an alternative to employee share schemes, have remained surprisingly popular: Loan funded plans involve the company making a limited recourse loan to an employee to acquire shares in the company; the loan is interest-free and allows the employees to benefit from the capital growth in the shares; any gain is only subject to CGT.

A common tripping point for startups is establishing their market value: any options issued to employees need to be issued at a business’s current market valuation. Yet finding a true valuation for new companies is often difficult - and costly. A ‘safe harbour’ valuation methodology is available, that is based on the startup’s net tangible assets. The safe harbour provides certainty for the startup, their employees and avoids the need for a costly valuation process.

A big potential pitfall is accurately determining revenue numbers. The ‘aggregated turnover’ threshold at $50 million sounds generous, but there is a sticking point: the threshold may need to include revenue numbers for significant or ‘angel’ investors.

An angel investor’s revenue will count toward the threshold if they take a 40% or higher stake in your startup. In practice, this means that if an organisation with $100 million in annual revenues takes a 40% stake in your company, their revenue will be included towards the $50 million threshold. If they take a 30% stake, their revenue is not included.

While we haven’t seen anyone disqualified yet, startups should note that it’s a hard threshold, with no leeway. A few percentage points either way can easily see your startup break through the threshold.

Discovering your angel investors’ revenues means startups need to go outside their group to obtain information, which takes extra time and can present commercial issues around obtaining that information.

Early experience suggests that the threshold isn’t a problem for newly minted startups in their first or second year. The problem can be more pronounced with more established startups; we have already seen several cases where complexities around the interpretation of the rules arise among startups with more than three years’ operation.

These cases require more financial analysis, and more effort to establish whether a shareholder’s turnover needs to be counted in the startup’s revenue numbers. They usually require a more intense review of tax law.

The $50 million aggregated turnover introduces another quirk: some startups may not qualify every year. The threshold is calculated on the most recent financial year’s revenues. Given startups (and their investors) may experience big fluctuations in revenues, there is no guarantee a startup will qualify every year.

What happens when a startup does cross the $50 million threshold? Any previously arranged employee share schemes still stand. Crossing the threshold only impacts new equity and a startup may find that it qualifies in a year subsequent to a previous year when they may have failed the tests. This may introduce some unwanted complexities and a need to re-assess the qualification criteria every year before a grant is made.

While it may be tempting to consider adopting a loan-funded plan as an alternative, running an employee share scheme alongside a loan-funded plan might impose a higher administrative and cost burden.

Being able to share equity with employees is important for startups because new companies don’t always have the cash available for high salaries and regular bonuses. For employees, the opportunity to take an equity stake in a company poised for growth is a major attraction for joining a startup.

While the new regime provides better opportunity, it’s still a potential minefield.