Startups are generally cash-poor. Unless your venture has raised a substantial amount of external funding through angel investors or venture capitalists, it is likely that it is funded from your own savings – or from your friends & family who believe in both you and your project.
Spending what little money you have can often be an emotional decision that hampers growth and development of the business – particularly when you feel a duty to spend your friends & family’s money wisely.
The most expensive part of a startup (or any business for that matter) is generally the remuneration of employees and contractors. This is particularly true if you need to recruit experienced and/or educated employees – such as engineers, programmers, or scientists. The high expense often means that early-stage startups cannot attract, retain, and compete for talent.
One possible solution is to provide equity in the venture (usually in the form of shares in a company, or options to acquire such shares in the future) to employees and contractors as a way of supplementing their cash-based remuneration. This has the dual benefit of saving cash whilst aligning the medium-to-long term interests of a startup’s employees with that of the organisation.
In theory, equity-based incentives encourage employees to work hard on delivering the organisation’s strategic goals and to act in the organisation’s interests. They can also encourage employee retention, and are often designed with that in mind – e.g. through tying the vesting of equity with time and/or performance-based hurdles which may be forfeited if the employees leaves.
However, in order for an equity-based incentive plan to be commercially effective, and to actually encourage participation, it needs to be designed in a way that does not result in adverse tax implications for participating employees and contractors.
In Australia, interests (such as shares or options) issued under an employee share scheme (ESS) are typically taxed in one of three ways:
- Taxed upfront (sometimes eligible for a reduction in the assessable amount);
- Startup concessions; and
- Deferred taxation.
The startup concessions are generous and allow the amount that the employee is assessed on upfront to be reduced to nil. Any growth in value from the date of grant until disposal is then subject to capital gains tax and may be eligible for the 50% discount.
Under these concessions, it is possible in some instances to issue ESS interests for nil consideration without any income tax payable upfront. However, there are a number of conditions that apply and ultimately employers will need to weigh up the commercial objectives when designing the plan.
The tax provisions that apply to a grant of ESS interests will depend on the rules of the ESS, the terms & conditions made to the employee in an offer to participate, and the employee’s own circumstances.
An employer may find that the grant of ESS interests to one employee may qualify for deferred taxation, whereas the same grant of ESS interests to another employee under the same ESS might be taxed upfront. It is therefore imperative that employers receive tax advice when designing an ESS and granting interests to employees to ensure that the employees’ tax implications are being managed in order to achieve the commercial objectives of the ESS (i.e. incentivising and remunerating employees).
However, when it comes to designing an ESS, the golden rule is to design the scheme rules and the terms of the offer made to the employees in such a way that the point of taxation (i.e. when the employee is assessed and liable for income tax on the interests) aligns with the time in which they can dispose of the interests and receive cash.
Employees would generally not be encouraged to participate in an ESS if they are liable for income tax before they actually have the money to pay for their tax bill – particularly where the income tax is due years before they could actually receive any cash (if at all).
Another important tip is that ESS should always be documented and formalised as soon as an offer is made. Gone are the days of handshake agreements. Whilst attending to paperwork is not the sexiest part of running a startup, it is imperative that all agreements are formalised and that the employer’s statutory obligations are satisfied (e.g. lodging an ESS annual report with the Australian Taxation Office and providing ESS statements to employees).
For instance, you may find your employees getting impatient (and leaving) if you take too long to issue them with their ESS interests as promised.
Furthermore, you may find that in the time between the handshake agreement and formalising the grant, the market value of the company had grown substantially resulting in the employee being liable for substantially more income tax. Likewise, if they leave it too long, an employer may find their options in designing the scheme limited when they finally get around to issuing the ESS interests and the employee might not actually receive their interests on the terms that were originally promised.
Issuing ESS interests to employees can help incentivise and remunerate employees without dipping into your pockets.
However, you should ensure that everything is documented, all regulatory and compliance requirements are satisfied, and that you obtain specialist tax and/or legal advice to ensure that all of your risks are being managed and your commercial objectives achieved.
Author – Andrew Ravenscroft is tax advisor who provides specialist tax consulting services to pre-seed startups through to large listed companies.
Andrew’s primary focus is advising business owners and investors on the tax structuring of their affairs and on the tax outcomes of mergers, acquisitions and exit events. He also advises start-ups and other tech-focused enterprises on establishing tax-effective employee share schemes to remunerate and retain key employees, and confirming whether investments in tech companies qualify for the early-stage innovation tax offset and other tax concessions in order to attract investors.
Andrew is the former treasurer of eGroup, and a former co-founder and CFO of a Perth-based tech startup that raised seed investment and sold products to over 30,000 customers across 60 countries. He understands the key business and finance-related issues that arise for start-ups and likes to use his experience to help founders in their entrepreneurial journeys.