For early stage high growth companies, shares or share options are an important component of the remuneration package for key employees, to ensure they are appropriate incentivised and aligned.
The tax considerations have changed and best practice has developed. It is timely to update and refresh the key structural and commercial considerations
KEY HIGHLIGHTS
- Anticipated tax changes appear to have closed the lid on clever “option-like” structures which seek to not only avoid any upfront tax, but also any tax on share value gains prior to the date that the employee fully and irreversibly acquires the shares (eg. pays off any associated limited recourse loan). While not enacted yet the changes will have retrospective effect, so we should assume they will apply to schemes adopted now.
- If the key objective is to defer any tax until there is more certainty that a realisable gain can be made, then straightforward share options are likely to be the preferred structure. They generally offer more flexibility and tax certainty than the “option-like” structures.
- The future exercise price at which options can be converted to shares can be less than current market value (or even nil value), without triggering upfront tax. A lower or negligible exercise price may be appropriate where the options are granted in lieu of salary.
- The option exercise period need not be a finite period (where it is often difficult to predict an appropriate timeframe within which a liquidity event is likely to occur). The option period can be indefinite until an appropriate ‘trigger event’ occurs.
- A key objective of employee share schemes is to retain and align key staff while they remain important, having regard to the company’s stage of development. The vesting period should strike an appropriate balance between retention (where important to the company) and ensuring the employee can exercise options which have already been ‘earned’.
- Consider establishing a nominee company to hold employee shares when they are issued. There are a number of potential benefits for the Company.
- The Financial Markets Conduct Act exemption for employee share schemes has some anomalies which may nullify its usefulness if a different share class is offered to employees (eg. non-voting shares). However there are a workarounds and, for start-ups with only a few senior employees participating, most employee shares can be issued under other exemptions.
- Beware a finite employee share pool. The pool should grow alongside the company’s capital base so each capital raising creates more headroom for employee shares.
THE DETAIL
Tax and Structure
Pending Tax Amendment
A tax bill was introduced in April 2017 which, when enacted, will modify the tax rules relating to the taxation of employee share schemes. Whilst timing for that enactment is uncertain, we should assume it will be enacted. The bill will have retrospective effect for any employee scheme put in place with a view to beating the new rules, so the prudent course is to design any new scheme on the assumption that the new tax rules will apply.
The new bill will largely close the lid on employee share scheme structures which are like share options in substance, but seek to achieve more favourable tax treatment. Share purchase structures like share/ loan arrangements, convertible notes and partly paid shares, where the employee is effectively protected against a future fall in value of the shares, will almost certainly be treated like options for tax purposes. So like options, no tax will be assessible when the securities are granted, but tax will be payable in the future when the securities are deemed to be fully acquired and the employee assumes the value downside risk. At that time the taxable benefit will include the share value appreciation up until that assessment date.
Structure Choices
Now that the potential tax benefits of more complex “option-like” arrangements appear to have been nullified, the structure choice has been simplified to a choice between issuing shares upfront or granting shares options. The respective tax treatments and other some key considerations are described in the below table:
| Description | Tax treatment | Key considerations and other comments |
| Issue shares upfront | No tax payable (now or in the future) if the shares are issued for market value.
However, if the market value is not paid, tax will be payable on the discount (treated as an employment benefit). Any tax paid will provide a corresponding deduction for the company (just like PAYE). |
Most tenable if the employee can acquire shares before they have significant value. Best scenario (where practical) is to issue “founder shares” on incorporation before any IP/assets are transferred to the company and before an employment relationship exists or investment occurs. But still worth considering if a low current market value can be justified and there is strong confidence about future value upside (which would be taxable under an option structure). The employee makes the risk assessment on whether that upside is most likely to be achieved.
The company might still loan the purchase price for the shares on interest free terms, but if recourse is limited to the shares (eg. the employee can put the shares back to the company in full satisfaction of the loan), then the arrangement will be treated like options for tax purposes. Interest free terms won’t trigger FBT issues provided the company adopts a dividend policy. Where vesting (or reverse vesting) conditions apply, the acquisition date will be deferred for the shares subject to vesting until they are free of vesting conditions or potential claw-back. The company may agree to pay the employee a cash bonus to cover the tax. The cash cost to the company is still less than paying the full share value as PAYE (no more than 33% instead of the 100% which would apply if the corresponding remuneration was paid in cash). |
| Grant options (or enter another “option-like” structure). | No tax now but tax will be payable in the future on the assessed benefit when the options are exercised (being the difference between the exercise price and market value at that time). | Employees avoid the risk of paying tax now on shares which might never realise any cash benefit to the employee. Tax is only payable if the options are exercised (being an employee choice if the employee believes or knows that the options are “in the money”).
Ideal scenario is that options are exercised and tax is only payable at a time when the shares can be immediately sold, so the tax is paid out of actual profit at that time. The company will get a tax deduction benefit on the assessed employee remuneration at the time the options are exercised. There is more chance that this deduction will have value for the company. If it does, the company might consider paying a bonus to the employee at that time to cover all or some of the employee tax. |
Proposed start-up reforms
The IRD issued a further consultation paper in May 2017 proposing further reforms for the specific benefit of start-up/ early stage companies. The proposed reforms would defer any recognition of income on employee shares for tax purposes by up 7 years, until an IPO or other liquidity event occurs (the assumption being that the employee will then have an opportunity to realise the shares to pay the tax). However, with or without this reform an option scheme can be structured commercially to achieve similar treatment.
Key Commercial Variables
The key commercial variables for share options are discussed below.
Exercise Price
The exercise price is the price for which shares can be purchased when options are exercised.
Most typically the exercise price is equivalent to the market value of company shares at the time when the options are granted, so the employee has the opportunity to benefit from value creation over the option period (but doesn’t benefit from value already created). That ensures alignment with the company and shareholder interests to increase share value and is appropriate where the options are provided as an incentive component of the remuneration package, (in addition to a base salary paid in cash).
Where options are granted in lieu of salary, (so cash salary is sacrificed for options), there is a reasonable argument that the exercise price should be discounted below current market value or even set at a nominal value or nil. The grant of, say, 100,000 options at a market value of $1, is not equivalent to $100,000 of value. On the date of grant the options arguably have no value, or at least any value is wholly contingent on future share value appreciation. They may be worth $100,000 in the future if the shares double in value during the exercise period, but projections of future earnings and share value appreciation will already be factored into current market value (with appropriate risk weightings).
The opportunity to buy shares at today’s price within a future period should have some upfront value, but that value is very hard to determine (noting the options can’t be traded) and will be affected by other terms such as the length of the exercise period, any pre-conditions to exercise, etc. That value is likely to be somewhat less than today’s market value of the shares which can be acquired and may be negligible. Another way to look at this is as follows:
- if the company chose to issue shares upfront (rather than options) in lieu of salary, it would issue shares which have a value equivalent to the salary forgone for no additional consideration (i.e. for free);
- the only difference with options issued with a nil exercise price is that the employee doesn’t get the shares upfront but can chose when to pick up the free shares and trigger the tax consequences of doing so;
- deferring that tax date is likely to benefit the company as well as the employee, as the company is more likely to benefit from the tax deduction it receives on that tax date if that date is deferred and may get a larger deduction (if the shares have appreciated in value).
For clarity, there are no immediate tax consequences of granting options at a discounted exercise price. Tax is only assessible at the time options are converted to shares (or possibly later if the proposed new start-up rules come into law).
Exercise Period
The exercise period is the period during which the option can be exercised.
The longer the exercise period before the option expires, the more beneficial that is for the option holder (particularly if the issuing company is a growth company which is not paying a dividend yield). A longer period gives more time for the share value to appreciate and for a major liquidity event to occur. It also allows the holder to defer payment and any associated tax consequences longer. If the option is in the money the option itself has value. The holder can sit on that value without exercising the option until the expiry date (and there is generally no benefit in exercising earlier unless the company is paying an attractive dividend yield or the employee expects further value upside and wants to crystallise the tax liability earlier).
The ideal scenario for the holder is to be able to defer exercise of the options until the time of a sale or other liquidity event, so that the holder can effectively realise the value differential between the exercise price and the market based sale price at that time, without having to fund the purchase of the shares andr any tax payable on exercise of the options or take any risk that the market value will be realised.
A typical exercise period for options issued by early stage companies is 5 years. However it is not necessary to set a finite exercise period. It is possible to have an open-ended exercise period which continues until such time as a defined liquidity event occurs. In that case I would normally include a right for the board to trigger the requirement for options to be exercised (in its discretion if it decides that continuation of the options is no longer in the company’s best interests) after a set finite period (eg. 5 years).
Vesting
Options often vest progressively over an initial period after the options are granted where one of the key objectives of most option schemes is key staff retention (i.e. incentivising key staff to stay).
A typical vesting period is 3 years, with options vesting in equal annual tranches over that period (but can vest at more frequent intervals or even monthly). However to the extent that options are granted to recognise services already provided or in lieu of salary for a period already worked, those options should vest immediately when they are granted.
The key vesting condition (and often the only one) will be the employee remaining in the employment of the company, although vesting might also be linked to achievement of certain performance targets or other conditions. In some cases, there may be a direct link between the number of options which vest and performance deliverables.
Only vested options can be exercised at any given time. If options expire or are terminated before vesting occurs then the holder will never have the opportunity to exercise those options.
However vesting might be accelerated in certain circumstances, such as upon occurrence of a trigger event.
Termination and Good Leaver/ Bad Leaver
Options will often terminate, or the expiry date will usually be accelerated, if the holder ceases to be an employee. Whether the holder then has an opportunity to exercise the options which have vested before they leave generally depends on whether the holder is a good leaver or a bad leaver.
There are short and long definitions to distinguish between a good leaver and a bad leaver, but no matter how long and complex the definition there will invariably be a grey area between the two categories. In general terms:
- a bad leaver is someone who is terminated for cause or terminates their employment without good reason or without the company’s sanction (eg. to go to a competitor);
- a good leaver is someone who is terminated without cause (eg. redundancy) or terminates voluntarily with good reason (eg. retires for health or personal reasons).
Normally the board has some discretion to regard the option holding employee as a good or bad leaver in the grey areas, such as when the employee wants to leave for personal or other reasons and they are no longer regarded as a key employee (the company may be quite happy to save the salary cost and there is a mutual parting of the ways).
All unexercised options held by a bad leaver (whether vested or not) will, almost invariably, terminate immediately. However a good leaver will usually be given a reasonable window (eg. 12 months) following cessation of their employment within which they can exercise their vested options. The board will usually have discretion over the length of this window where a minimum window will be specified, but the board may choose to allow the option holder to continue holding the options until a trigger event occurs or until such time in the future as the board decides they should be crystallised. Where the option holder dies or is permanently incapacitated the board may be inclined to exercise its discretion more favourably.
Trigger Events for Early Exercise
Normally there will be certain trigger events which bring forward the expiry date of the options. The typical trigger events correspond to major liquidity events such as an IPO, a sale of a majority of the company’s shares or assets or any analogous event (with some board discretion to determine whether the event is a suitable liquidity event). If no finite expiry date is specified, the trigger events will usually include a board determination that the options should be exercised in the best interests of the company, usually exercisable after a set period from the grant of the option (eg. 5 years).
If a trigger event is about to occur, the holder is usually given a time window within which to exercise their options (or else they will lapse). Exercise of the options will allow the holder to participate in the liquidity event.
Conditions of Exercise
In some instances, the right to exercise options might be conditional on the option holder taking certain actions to facilitate a trigger event, such as supporting the sale process and staying on to assist a purchaser for a period post sale.
Other variables relating to types of shares and ownership
There are a number of variables relating to the types of shares which are issued to employees under an employee share scheme, restrictions which might attach to those shares and how they are held. For example, employee shares may be:
- non-voting or only have limited voting rights;
- subject to restrictions on subsequent transfer;
- subject to repurchase rights if the employee subsequently leaves the company;
- held by a nominee rather than directly by the employee.
Reasons why the company might require employee shares to be held by a nominee include:
- keeping the company under the threshold of 50 shareholders (now or looking into the future), which will trigger the Company becoming a code company under the Takeovers Code;
- to better secure any repurchase rights or restrictions on transfer, (where they apply);
- maintaining a cleaner share register which does not have multiple small shareholders.
A company which has multiple small shareholders may be less attractive to new large investors. A large number of small shareholders may also make it harder to pass written shareholders’ resolutions without calling a physical meeting (where a written resolution must be supported by shareholders who not only hold 75% of the voting shares, but also represent 75% of shareholders by number of shareholders).
FINANCIAL MARKETS CONDUCT ACT EXEMPTIONS
The Financial Markets Conduct Act has an exemption for securities offered under employee share schemes, where raising capital is not the primary purpose.
The exemption allows a company to issue shares or grant options equivalent to 10% of the company’s voting shares (assuming the employee shares or options are for voting shares).
However the exemption is unhelpful if the employee shares or options are for non-voting shares or any other class of security (as the 10% limit is based only on the number of securities which already exist in that class). If a non-voting or other class of shares is created for employee shares then the first issue of shares in that class will comprise 100% of that class, no matter how low the proportion of the company’s total capital represented by the employee offer. This is non-sensical legislative drafting, but that is the exemption.
Thankfully there are workarounds if the company wishes to offer different voting or other rights to employees. For example, the shares could be voting shares, but each employee might grant an irrevocable proxy to someone else (eg. the board chair or a nominee which holds the shares), who might be required to vote in the same way as the majority vote of other shares (so they never affect the voting outcome).
You might also question why a company would be concerned about offering voting securities to employees. Such securities can’t be voted until they become shares (options don’t confer voting rights) and, if they do become shares, they are unlikely to ever represent more than 15% of the voting capital. Further, ownership will be dispersed, so they won’t necessarily be voted as a block (unless the company puts in a mechanism to facilitate this).
The other key consideration is that the employee share scheme exemption is supplementary to other exemptions, so offers to employees which are otherwise exempted will not count towards the 10%. One such exemption is for close business associates, which definition expressly includes any director or senior manager (as well as persons who have a close professional or business relationship with a director or senior manager). Many start-ups or other early stage companies only have senior managers, or else most (if not all) of the employee securities are only offered to such managers (being the key people who need to be aligned and incentivised).
Andrew Lewis Law ©
Disclaimer: This article does not constitute legal or taxation advice and is only current based on laws which exist as at March 2018