Start-ups welcome a review of Employee Share Schemes

The government’s review of the laws on employee share schemes (ESSs) is a welcome move which could give entrepreneurial and technology start-ups a boost in the global war for talent and investor capital.

The date for submissions to the Coalition government’s consultation paper on ESS arrangements for start-ups closed on 7 February 2014. This review follows a similar process started by the previous Labor government back in August 2013. It was put on hold following the election in September and subsequent change of government.

Clayton Utz partners Mark Friezer notes: “Employee options arrangements are fundamental in remuneration structuring for start-ups, particularly in the technology sector. Typically, these companies do not have the cash-flow to reward employees by conventional salary or cash bonuses. The granting of an option is a cost-effective way of attracting and incentivising talent.”

Like many others, he says new employee share plan tax rules which came into play in 2009 have created significant problems, particularly for start-ups.

“Previously, the ‘discount’ on share options was only taxed when an option was exercised. The new rules accelerated the taxing time to the point at which the options vest. This means that if an employee is granted an option, that employee needs to include the market value of the option in assessable income in the year that it is granted, unless the option is subject to forfeiture. The problem with this scenario is that the tax liability accrues even though the employee hasn't realised any economic value for the option,” Friezer says.

Chris Beare, chairman and general partner of Accede Capital Venture Partners and adirector of Info Technology, believes that ESSs are vital to start-ups. “ESSs promote employee ownership,” he says. “It's more than just being a part of the remuneration package. It's being part of the company. This makes a big difference to the culture of a start-up. People are prepared to work harder and take more risk when it's their company and not just a job. An ESS isn't just a means of saving cash by paying people less; it's the motivational aspect of sharing ownership in the company.”

Similarly, Darius Coveney, chief operating officer of IPscape, observes: "Having worked with a number of high growth businesses, both here and in the UK, I believe the current ESS rules here in Australia are hindering local growth. The rules add administrative overhead and cost, and leave our offshore competitors much better able to compete for global IT talent - talent that, in a lot of cases today, doesn't even need to leave home in order to change global employer. If we can stop talking about this change, and follow our global friends in simplifying the rules and the administration of ESSs, we can go a long way to helping the already growing base of Aussie companies building competitive global businesses."

In its submission in response to the government’s discussion paper, the Australian Association of Angel Investors notes that the current legislation is based on a fundamentally flawed premise that equity and cash are interchangeable in the hands of the employee.

“That can be considered true for less than two per cent of all Australian companies and not at all true for the more than 96 per cent of companies that the Australian Bureau of Statistics identifies as small businesses. For the vast majority of Australian companies, the treatment of equity awarded to an employee as taxable personal income in the year that it is awarded is a crippling inhibition.

“The purpose of an ESS is to align the interests of a company, its shareholders and its employees/directors towards the longer term success of the business. By sharing the risk in the equity all parties expect to realise substantial financial revenue in the future.”

In a submission from the Innovation Centre Sunshine Coast, CEO Mark Paddenburg, says: “The Australian taxation system has become overly complicated and the ESS legislation is another clear example of just how non-competitive our start-up ecosystem has become when you benchmark with the OECD (and in particular with the best - the US, Canada and Israel). I believe the ESS, in its current format, should be abolished… To be globally successful, secure the right team and scale quickly, most start-up founders will need to augment the reward for effort with shares or options that mean something and represent tangible value to the recipient. Currently, employees are required to pay income tax in the year the blue sky equity is acquired, rather than on disposal (or a CGT event).

“Start-ups have enormous pressure on their early stage finances. Many of our members confirm that having an effective ESS can be a very useful tool that start-ups should be utilising (as is the case in most of the markets that our start-ups compete with).

“Additionally, Australia has a limited angel/venture capital market making it challenging to fund start-ups here. Having an effective ESS (and also a pragmatic crowd funding regime) can help mitigate start-up risk and encourage jobs growth. I believe if we continue to disadvantage Australian start-ups, we will continue to drive innovation offshore.”

“One thing that everyone seems to agree on is that ESSs are broken under current legislation, but it’s now time we moved beyond the problem to helping government formulate a solution,” says Damien Tampling, technology, media and telecommunications partner at Deloitte.