Deep Dive into ESOP's (1/3)

With the recent Federal Budget announcement targeting positive changes to the ESOP tax regime, we see ESOPs becoming increasingly popular and well used.

Drafting a comprehensive ESOP plan by having rules that reflect the company’s values is crucial to ensuring that the ESOP is successful.

Improve cash flow

Also called an Employment Option Plan, an ESOP creates the structure to allow a company to offer employees options to acquire shares in the company. 

The benefit of an ESOP, particularly for early stage companies, is that it can preserve cash while incentivising employees who will benefit from the company's long term growth.

ESOP tax can be deferred

ESOP’s are used to offer to employees the option to purchase shares in your company. If you do it right, your company may be able to qualify for tax deferral under the ATO’s startup tax scheme (subject to eligibility criteria and the company’s ongoing compliance).

Note for the ‘startup’ tax concession to apply, the scheme can permit options over ordinary shares only, and the exercise price needs to be the “fair market value” of an ordinary share as at the date on which the options were granted.

Under Australia’s unique system, you can also create a tax-deferred scheme that is not subject to the ‘startup’ tax concession limitations, including the ability for options to be issued with a nil exercise price.

These issues should be considered with your advisers before implementing an ESOP.

What does an ESOP typically cover?

1. Vesting timetable and performance-based vesting criteria

The ESOP will typically provide for specific options to vest only on the satisfaction of certain criteria. For example, a portion of an employee's overall options may vest over a certain period provided that the employee remains employed (time vesting). Other times, it can vest on the employee meeting KPIs or accomplishing predetermined tasks (performance-based vesting). Common KPI metrics are linked to profit and revenue such as earnings per share, business acquisition and marketing-based goals. The vesting timetable or schedule will set these conditions out.

2. Forfeiture conditions for good leavers and bad leavers

Options may also be forfeited on the failure by an employee to meet vesting criteria (such as by leaving before the time vesting schedule is complete or failing to meet KPIs). Usually though ESOP’s will offer employees the chance to leave as either a 'bad leaver' or 'good leaver' (often determined in the discretion of the company’s board).  For example, an employee may become a bad leaver if that employee breaches their employment contract or commits certain acts (like criminal activity). In this case, companies may be able to force the bad leaver to forfeit both vested and unvested options.

3.  Procedures on an exit event

An exit event typically occurs when a company is listing on a public exchange or going through a business or share sale. The ESOP will set out what will happen to any unvested options on an exit event, but companies can allow all unvested options to vest immediately prior to the exit event so that employees can benefit from the exit event.

4.  Drag-along provisions

Optionholders may frustrate or exploit a proposed sale, so ESOP’s should address this concern by, for example, including a provision that requires conversion of the options prior to the sale or allowing for the options to lapse if not exercised before the sale. Typically then the optionholders will become shareholders and will be bound by the drag-along provisions in the company’s shareholder’s agreement.

Read more in Part 2

In the next part, we answer what the difference between vested and unvested options is and other frequently asked questions about ESOPs!

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