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How does an employee share scheme work?

The basic purpose of any employee share scheme is to give participants the opportunity to share in the profits and/or the capital value of the company as it grows over time. However there are a variety of different ways that employee share schemes work, and there are a range of different factors that you will need consider if you are planning to implement one. Read on to learn more.


Download our Employee Share Scheme Roadmap

An essential tool for setting up an ESOP. 

This checklist will help you better understand the process of setting up an ESOP, and make sure you are asking the right questions and thinking about all key considerations.

  • Practical commentary to help you understand the process of creating an employee share scheme
  • Easy-to-follow questions to guide you on your journey
  • Practical suggestions to help you move on to the next step

Overview - the mechanics of employee share schemes

In Australia, employee share schemes are generally structured in one of three ways:

  • Share Schemes, where participants acquire shares,
  • Option Schemes, where participants receive options that give them the right to acquire shares later, or
  • Phantom Schemes, which do not involve equity, but instead involve cash bonuses that are intended to mirror an equity outcome.

Within these three categories, schemes are structured differently depending on the purpose of the scheme and the company's circumstances.

For example, a scheme that is created with the intention of attracting new team members is likely to be structured differently to one that is intended to operate as an immediate succession plan.  

Similarly, a scheme for an early stage start-up is likely to look very different to a scheme for a large company with a strong track record of maintainable profits.

Some schemes will require participants to buy in, some will not. Some will allow participants to buy shares at a discount, some will not. Some will not deliver any benefit to participants until there is an exit event (eg business sale or IPO), whereas others will try to reward participants at an earlier stage.

In short, there is enormous variety in the ways that employee share schemes work in Australia. 

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5 reasons to consider an employee share scheme

There is a common misconception that employee share and option schemes (ESOPs or ESSs) are the exclusive domain of tech start-ups and large corporates.  However there are a number of reasons why all companies, particularly privately owned ones, should consider them as part of their overall strategy such as: 

  1. attracting high quality staff,
  2. retaining strong performers,
  3. changing the way your people think and behave,
  4. creating or expanding opportunities to exit, and
  5. taking advantage of potential tax efficiencies.

There are also numerous reasons why companies don't adopt them, such as their cost and potential complexity. Their real value is often not seen until several years after their implementation. Owners are often reluctant to give up control or allow their ownership stake to be diluted.

The process of considering a share scheme involves a careful analysis of the owners' commercial objectives, and a weighing up of the various pros and cons. If a decision is made to go ahead, the focus is then on designing a scheme that manages the risks and otherwise aligns with the owners' objectives. 

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4 ingredients for a successful employee share scheme

Creating a successful employee share scheme is all about careful planning.  Because there are so many ways you can design an employee share scheme, it is important to keep a few basic principles in mind. 

  1. Make it attractive to participants.
  2. Have a clear picture of what you are trying to achieve from it.
  3. Make sure it is tax efficient.
  4. Seek specialist advice early on.

Engaging a lawyer who regularly advises on employee share schemes will give you access to case studies, examples and expertise gained from past experience.  For the best results, we always suggest engaging your tax advisor and lawyer at the same time, so that they can work with you as a team.

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How do employee share schemes work?

The simplest form of scheme is one where employees are given the opportunity to buy shares in the company.

There are two main challenges with this type of scheme: 

  • participants do not normally have sufficient financial resources to buy their shares (at least not upfront); and 
  • if a discount is applied to the share price or participants are given shares, this can trigger an immediate tax liability on the part of the participant.  (The discount is effectively treated as part of the employee's taxable income.)

To deal with the first point, non-recourse loans are often made to participants to enable them to pay for shares over time. 

There are ways of structuring share schemes to minimise the potential tax consequences for participants.  For example, in some cases it may be possible to structure the scheme so that participants can defer paying tax on any discount to the price of their shares for several years or so that the scheme can take advantage of the start-up tax concession (see more on this below.)


How do employee option schemes work?

Whereas share schemes may see participants being rewarded through dividends, option schemes are typically more focused on future capital growth.

In some cases, options will not be capable of being exercised until there is an exit event (such as a business sale or an IPO).

The key elements of an employee option scheme are:

  1. The company issues options to participating employees.
  2. The options give participants the right to buy shares in the company at a specified exercise price.
  3. There are normally conditions that must be satisfied before an option can be exercised, such as performance targets or the lapsing of a specified period of time (known as a ‘vesting period’).
  4. There are usually restrictions on a participant’s ability to sell options or shares acquired under the scheme.
  5. Options are typically forfeited if a participant leaves the company during the vesting period.

There are a variety of commercial and tax considerations that need to be taken into account in designing an option scheme.

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What is the vesting period in an ESOP?

The vesting period in an ESOP is the initial period when participants do not have access to all of the rights that would otherwise attach to their options or shares. This article explains how they work.

Under an ESS or ESOP, participants receive shares or options in the company that employs them. Sometimes, these shares or options will be subject to a ‘vesting period’.

The vesting period is the period between the date the options or shares are issued, and the date the participant is able to exercise all of the rights that attach to them.   

Where there is a vesting period, participants will not receive the benefit of all of the rights that attach to their shares or options until after the vesting period has expired.

Where the ESOP involves options, participants are not permitted to exercise an option until after the vesting period has expired. If a participant leaves the company during the vesting period, any unvested option would lapse or be taken to have been forfeited.  

Where the ESOP involves shares, similar principles would apply.  If a participant were to leave the company during the vesting period, any unvested shares would typically be forfeited or sold at a discount (usually by way of buyback or sale to a third party for no consideration or at a discounted price).  

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The tax basics of employee share schemes

A well-structured employee share scheme can deliver a financial incentive to employees that, in net terms, could significantly exceed any amount they could stand to receive under a traditional salary or bonus arrangement.

Whereas salary and cash bonuses will always be taxed at marginal rates, some employee share schemes open the door to substantial discounts on capital gains under the CGT regime.

However one of the main drawbacks of employee share schemes is that they can be incredibly complicated, particularly when it comes to tax. The employee share scheme tax rules are rigid and, in some respects, highly prescriptive.

Some tax concessions will only be available if you structure your scheme in a particular way.  For example, some concessions will only be available if the interests issued to employees are ordinary shares, including voting rights. For some companies (not all), this is not an attractive proposition.  In addition, some types of concession will only apply to start-ups, as defined in the tax rules.  (See more on this below.)

Tax considerations should never be the driving force in the design of an employee share scheme. However you will need to consider them carefully, in the context of your commercial objectives, to maximise the potential incentive you are aiming to provide.  We would strongly recommend engaging specialist lawyers and tax advisors to work together in designing any ESOP, to ensure the best outcome is achieved.  

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Eligibility criteria for the start-up concessions

In an effort to make employee share schemes more attractive, the Australian Government allows certain concessions to companies that are classified as 'start-ups'.

These concessions are designed to reduce the tax that participants would otherwise be liable to pay in connection with the interests they acquire under the scheme.

Broadly, a company will be classified as a start-up for the purposes of these rules where:

  • it has an aggregate annual turnover over of less than $50 million;
  • it is less than 10 years old;
  • it is not a listed entity, it is an Australian tax resident and is not in the business of trading securities.

In addition to company eligibility requirements, to qualify for the concessions there are also eligibility requirements regarding the rules of the scheme and its participants. 

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ESOPs and Shareholders Agreements

If participants under an employee share scheme will become shareholders of the company, you will need to consider whether your shareholders agreement requires any changes (or whether you might need a new one).

A shareholders agreement sets out the rights and obligations between the shareholders of a company.  It is separate from the company's constitution.

A shareholders agreement will typically explain (among other things):

  • the nature and objectives of the business,
  • how decisions will be made,
  • when shares can be issued or sold, 
  • the consequences (if any) of a shareholder ceasing to be an employee,
  • how disputes will be resolved.
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Employee Share Scheme Roadmap

Your journey to a successful ESOP starts here.