Employee Equity in Start-up Companies

by Employee Share Ownership on January 5, 2015

iStock_000044712886SmallThe Government is to be commended for its Industry Innovation and Competitiveness Agenda and for the announcement in particular of more tailored settings for the taxation of employee shares and options issued by start-up companies. The tax policy reflected in these settings is plainly appropriate and most welcome. Without them, entrepreneurial investment in Australia would continue to trail competitor countries such as the United States, the United Kingdom and Singapore.

Industry Innovation and Competitiveness Agenda

Employee shares and options issued by start-up companies
Removing practical impediments to policy

The key attributes of the Industry Innovation and Competitiveness Agenda (II&CA) policy for the taxation of employee equity in start-up companies, from an industry perspective, are:

• Taxation of employees only upon realisation of benefits; and
• Taxation of benefits as capital gains rather than as income.

The policy recognises that start-up company employees are investors of their time rather than being remunerated for it, and therefore that they should be taxed as any other investors. Employees of start-up companies in competitor countries are taxed on essentially this basis and Australia would benefit from equivalent treatment of employees.

However, some aspects of the proposal as outlined in the II&CA announcement documents could in practice prevent this excellent policy realising its intent. These are outlined below:

1. Unlisted Requirement
It ought not be assumed that listed companies have ready access to capital. Many have listed to fund R&D projects and are yet to make profits. They remain start-ups in every sense. Nor will the new regime permit concessional treatment of already embedded value, only growth in value (except to the limited extent of the proposed small share discount exemption), so it is incidental that stock exchange pricing indicates at least some already established value.

The II&CA does not explain its denial of start-up status to listed companies. It is hard to see a justification. If otherwise a company satisfies the start-up criteria, why would quotation of its shares change its character?

A significant practical effect of this rule would be to disqualify highly innovative sources of future growth for our economy. We submit there is no reason to discriminate against listed companies. They should be dealt with as any other start-up.

2. 12 Month Rule for CGT Discount
In ordinary circumstances a pre-requisite for the 50% CGT discount is that the asset in question has been held 12 months prior to sale. This is broadly to ensure that the primary benefit of CGT treatment is only available for genuinely patient capital. In ordinary circumstances therefore, shares acquired on exercise of employee options must be held for 12 months to qualify for the 50% CGT discount.

We submit that it would not be appropriate to apply this rule to shares acquired on exercise of employee options issued by start-up companies.

The measure of success of a start-up company, and therefore a common vesting condition for start-up company options, is that the company is able to be sold. Employees in these cases are required to exercise their options and immediately sell their shares, to ensure that a whole-of-company sale is possible. A further 12 months holding requirement would in practice therefore frustrate the operation of the II&CA policy in many cases.

3. Three Year Holding Rule
The requirement for employees of start-up companies not to sell shares within three years of acquisition, or within 3 years of grant of options, will also require a ‘carve out’ in appropriate cases in order that large parts of the start-ups sector are not disqualified from the concession because of the need to retain the ability to sell the company at any time.

Employees of start-up companies are very often required to sell their shares when the company is able to be sold, to ensure that a whole-of-company sale can occur and that company value is not compromised by minority shareholders unwilling to sell. Employees therefore hold their shares or options subject to so-called ‘drag-along’ sale requirements and the legislation should reflect this practical reality.

The three year holding requirement will need to be appropriately ameliorated for these sorts of sales if the II&CA policy is to be workable in practice.

The rule will also need to cater for sales pursuant to ‘tag-along’ rights. To ensure that in practice employees of start-up companies are able to realise value when it is available, they are often given rights to participate in a sale of an unlisted company’s shares to a buyer of a controlling interest in the company. If the three year holding rule prevented these sales it would in practice mean that companies could not offer qualifying options to employees.

4. 5% Limit on Employee Holdings
In ordinary circumstances a pre-requisite for access to employee share plan taxation concessions is that the employee concerned does not own or control more than 5% of the company’s shares. It would be inappropriate to apply that rule in the start-up context.
In many cases start-up companies commence with a cornerstone capital investor and one or two key employees devoting large amounts of time to a venture for little current remuneration. It is not uncommon for these employees to be given more than 5% of the equity in the company. That does not make them any less “employees”, or otherwise warrant denying them access to the new regime.

The new tax rules should consider this limitation and look to ensure there is an appropriate carve out for start-up companies.

5. Up-front Valuations
The new regime is not intended to benefit share and option plans that provide already embedded value, except to the extent of the small share discount exemption. Options cannot be issued in-the-money and shares may not be acquired at more than a 15% discount.

Start-up companies in practice, therefore, will not be able to access the benefits of the new regime without the same expensive and problematic up-front valuations that the existing share and option plan tax rules currently require.

The answer is to also introduce ‘short-cut’ valuation rules, for which there are a number of precedents. Example short-cut valuations in this context might be found in the company’s last arm’s length share sale, its last capital raising, or its most recent audited financial statements. The most practical short-cuts would be a matter for development by the interested parties.

6. Small Discount Exemption
The small (max. 15%) discount exemption will require employees to pay the remaining 85% of the share price from after-tax dollars. This is an awkward and unnecessary requirement.

It would require employees to substantially fund the purchase price of shares in inherently unproven companies, and run directly counter to the policy of the II&CA announcement. It would unnecessarily frustrate, for example, most salary sacrifice arrangements.

A straight forward solution would be to make the exemption available for the ‘first 15%’ of discount provided. The remaining 85% discount would be taxable anyway, either up-front or on a deferred basis.

A still more practical approach would be to allow an exemption for the greater of a fixed $ amount or the first 15% of discount. That would permit the simpler alternative of an exemption for a small amount of free shares.

7. Cornerstone Investors
As mentioned above, many start-ups begin with a substantial or ‘cornerstone’ investor or sponsor. Given the funds they put at risk in a venture, these investors may initially retain a significant interest in the start-up company e.g., 51% ownership. Sponsorship of this nature is to be encouraged as it is a key ingredient of the start-up sector.

Therefore, ‘start-up’ classification should not be disqualified by characteristics of these investors, regardless of whether they are public companies, foreign companies, large companies or otherwise. The defining attribute of a start-up is that its employees are given equity in the start-up itself rather than in the investor.

8. Tax at Cessation of Employment
The taxation of start-up company option plans on CGT account is expected to overcome the problem of employees participating in these plans being taxed on cessation of employment. The income tax rules currently applicable apply tax at cessation of employment even if the employees concerned cannot sell at that point.

The proposed tax exemption for start-up company share plans providing no more than a 15% purchase price discount is likewise expected to overcome the problem of employees participating in these plans being taxed on their shares at cessation of employment.

Tax at cessation of employment should also be removed in the other instances where it applies. Vesting conditions and sale restrictions will often continue beyond cessation of employment, either because a sale event has not arisen or simply to promote long-term rather than short-term thinking. The new tax rules should encourage retention of equity in these circumstances.

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