An employee share option plan (ESOP) lets a startup give staff the right to buy shares later at a fixed price, so they share in the growth they help create. The company keeps control in the meantime. Options are not shares, option holders do not vote, and a well-drafted plan decides what happens to unvested options when someone leaves.

The hard part is the setup. The way you price the options decides whether your team gets the startup tax concession, and the same pricing decision can bring in stricter offer rules under the Corporations Act. Get both right before the first grant and you can offer early staff a real stake without spending cash.

What this covers

  • How an ESOP is structured and what the company needs in place before the first grant
  • How employees are taxed on options, and the conditions for the startup concession
  • The offer rules, what happens when someone leaves, and the mistakes founders make most often

What an ESOP is and how it is structured

An option is a right to acquire a share in the future, usually after it vests, by paying an exercise price set at grant. Until the employee exercises it, they are not a shareholder, with no vote and no dividends.

A typical ESOP for a proprietary company has two layers of documents:

  • Plan rules. The common terms for everyone: eligibility, vesting, exercise, leaving and a sale of the company. Good rules keep board discretion over who participates, grant sizes, vesting conditions and pricing.
  • Offer letters. One per employee, setting out their personal terms: how many options, the exercise price, the vesting start date and any vesting conditions. The letter incorporates the plan rules.

Vesting is either time-based (the employee stays for a set period) or performance-based (the company or the employee hits agreed milestones). Our guide to share vesting explains vesting schedules and cliffs in more detail.

What the company needs before the first grant

ESOP gaps are often found in due diligence, when an investor's lawyers ask how the options were approved. Put these in place first.

Board approval. The directors approve the plan and each grant. This can be done at a board meeting or by a written resolution signed by the directors.

Shareholder approval, in some cases. Shareholder approval is needed if the company will lend money to employees to buy shares, buy back employee shares under the plan, or take security over its own shares. A proprietary company can do this by written resolution if every voting shareholder signs, or at a general meeting.

Switching off pre-emptive rights. By default, the Corporations Act requires a proprietary company to offer new shares to its existing shareholders first, in proportion to their holdings. If your constitution has not displaced that rule, every exercise of an option would technically trigger an offer to existing shareholders. Most startups exclude the rule in the constitution or pass a standing shareholder resolution that carves out ESOP issues.

A plan for the 50-shareholder limit. A proprietary company can have no more than 50 shareholders, subject to some exclusions. Some startups hold ESOP shares through an employee share trust to stay well within the limit and to recycle shares from departing staff. A trust brings its own licensing and reporting questions, so it needs advice before you set one up.

How employees are taxed on options

Tax is where an ESOP is won or lost for your team. There is a default rule, a deferral rule and a startup concession.

The default: tax up front

If an employee acquires options at a discount to market value and no concession applies, the discount is added to their assessable income in the year they get the options. That is a tax bill on something they cannot sell.

Deferral

Tax can be deferred while there is a real risk the employee will lose the options, for example because they have not yet vested, or where there is a real restriction on selling them and the plan rules say deferral applies. Tax is then triggered when the risk and restrictions end, on sale, or after 15 years at the latest, on the market value at that time less what the employee paid. Since 1 July 2022, leaving the company is no longer an automatic taxing point, although one can still arise if a disposal restriction ends when the employee leaves.

The startup concession

For most early-stage companies, this is the one to design around. If it applies, the discount is reduced to nil. The employee pays no income tax when the options are granted, vest or are exercised. Capital gains tax applies when they sell the shares, with a cost base made up of what they paid for the options plus the exercise price. The 12-month clock for the CGT discount runs from when the options were granted, not when they were exercised.

The conditions include:

  • the company and its related entities are not listed on a stock exchange
  • the company was incorporated less than 10 years before the end of the income year before the options are granted
  • the company's aggregated turnover for that prior income year was no more than $50 million
  • the exercise price is at least the market value of an ordinary share at the time of grant
  • the employee's employer is an Australian resident
  • the plan requires employees to hold the options, or the shares from exercising them, for at least three years or until they leave the company
  • immediately after the grant, the employee holds no more than 10% of the shares or voting power, counting shares they could acquire under options

One condition that does not apply: for options, the plan does not have to be open to most of your staff. That suits a startup granting options to a few key hires.

The exercise price condition is the one founders trip on. Options granted at a nominal exercise price, such as one cent, will not qualify, and the employee falls back to the default rules. You need a defensible valuation at the date of grant. The ATO publishes approved valuation methods for the startup concession, and following one gives you a safe harbour. The directors must sign off, and the approved methods are not available if a change of control is expected within six months. Check every condition again at each grant.

The offer rules: disclosure and caps

Options are securities, so without relief an offer needs a prospectus or similar disclosure document. Since 1 October 2022, the Corporations Act has had dedicated relief for employee share schemes. What it requires depends on whether employees pay anything.

Offers for no payment. If participants pay nothing to take part, the requirements are light. The offer must go to eligible participants, it must state that it is made under the employee share scheme relief, and any trust arrangement must comply.

Offers involving payment. The conditions for an unlisted company are much heavier, and an exercise price counts as payment even if nothing is paid on grant. So a plan priced at market value for the startup concession lands in this category. The conditions include:

  • a monetary cap of $30,000 per participant in any 12-month period (plus 70% of dividends and cash bonuses received), which for unexercised options can build up to $150,000 over five years and falls away once the company lists or a sale agreement is open to the participant
  • an issue cap of 20% of the company's shares over three years, or lower if your constitution says so
  • an offer document setting out the terms, the risks, a general advice warning and a statement that the interests may have no value
  • a solvency statement, a valuation of the interests offered, and the company's most recent financial report, with a statement on whether it was audited
  • timing rules: for options, the company's financial information must reach participants at least 14 days before each exercise period

The other exemptions. The ordinary fundraising exemptions are still available, including offers to senior managers, small-scale personal offers (no more than 20 people and $2 million in 12 months) and offers to sophisticated investors. For a handful of early employees, one of these may be an alternative. We cover them in our guides to seed funding and convertible notes.

What happens when someone leaves, or the company is sold

No statute decides what happens to options when an employee leaves. The plan rules do.

Most plans use good leaver and bad leaver categories:

  • Good leavers usually leave in circumstances the company accepts, such as redundancy or retirement. They typically keep their vested options, can sell vested shares at a fair price, and sometimes have unvested options vest early, in full or pro rata.
  • Bad leavers usually leave after misconduct, serious breach or fraud. They typically lose all unvested options, and vested options or shares may be bought back at a reduced price.

Three drafting points come up again and again:

  • Penalties. A court has struck down a bad leaver clause that left an employee handing over shares for nothing, treating it as an unenforceable penalty. A discount that is proportionate to the company's likely loss, or tied to length of service, is far safer than outright forfeiture.
  • Objective tests. Whether someone is a bad leaver depends on whether the defined conduct happened. A company cannot label someone a bad leaver just because it believes, even reasonably, that they did something wrong.
  • Clear triggers. Plan rules that say unvested options lapse when employment "ceases" have been read to apply however the employment ended. Say what you mean, set a default category, and make the definitions hard for either side to game.

On a sale of the company or a change of control, many plans let the board accelerate vesting so some or all unvested options vest at once. Acceleration confers a benefit, so it does not raise the same penalty concerns.

How options fit with your shareholders agreement

The plan rules need to work with your shareholders agreement, not against it. Option holders are not shareholders, so neither your constitution nor your shareholders agreement binds them until they exercise. Once shares are issued, the constitution binds the new shareholder automatically. The shareholders agreement does not. It only binds people who have signed it.

That gap matters at exit. An employee shareholder who has not signed up to the drag-along clause may be able to hold out against a sale everyone else has agreed to.

There are two ways to close the gap:

  • make signing a deed of accession to the shareholders agreement a condition of exercising options
  • replicate the key shareholder provisions in the plan rules or offer terms

Either way, cover transfer restrictions and pre-emptive rights, whether employees can sell before a liquidity event, leaver treatment, tag-along and drag-along rights backed by a power of attorney, and confidentiality and non-compete terms. Keep the plan rules and the shareholders agreement consistent, or expect a dispute over which one applies.

Reporting and admin each year

Each year, the company must give participating employees an ESS statement by 14 July and lodge an ESS annual report with the ATO by 14 August. Diarise both from the year of your first grant.

Common mistakes

  • Nominal exercise prices. Pricing options at a cent loses the startup concession and leaves employees with an up-front tax bill.
  • No valuation, or a weak one. The exercise price, the startup concession and the offer documents all rest on it.
  • Leaving pre-emptive rights in place. ESOP issues may then need to be offered to existing shareholders first.
  • Using the wrong offer pathway. Treating options with an exercise price as a free offer skips the caps, the offer document and the timing rules.
  • No deed of accession. Employee shareholders who are not bound by the drag-along clause can complicate a sale.

Common questions

Can contractors and advisers get options?

Yes. Both the employee share scheme tax rules and the Corporations Act relief extend to directors (including non-executive directors), contractors and consultants, as well as prospective employees. Make sure your plan rules name them as eligible.

What if an employee will not give us their tax file number?

The company must withhold tax at the top marginal rate on the employee's ESS amount. Ask for the tax file number when the offer is accepted, not at the end of the financial year.

Key takeaways

  • An ESOP gives staff the right to buy shares later at a fixed price. They are not shareholders until they exercise.
  • Set the exercise price at market value, backed by a valuation, if you want employees to have the startup concession.
  • Options with an exercise price are a paid offer, so the monetary cap, the issue cap, the offer document and the timing rules apply unless another exemption fits.
  • Get board approval, deal with pre-emptive rights and line the plan up with your shareholders agreement before the first grant.
  • Draft good leaver and bad leaver terms that are clear, objective and proportionate.
  • Diarise the ESS statement and ATO reporting dates every year.

Hiring your first employees and want to offer equity without the tax and compliance traps? Talk to Plumlaw about a fixed-fee ESOP that fits your constitution, your shareholders agreement and the startup concession.