Resist the temptation to impose listed company schemes
Companies large and small are investing in start-ups and businesses that may one day disrupt their own.
The listed company strategy of contributing equity, rather than acquiring a start-up makes sense. A full acquisition by a listed company is likely to squash the entrepreneurialism of a start-up, whereas an injection of capital can provide fuel for more entrepreneurial fervor. However, apart from some input into shareholder agreements, directors representing listed company investors on start-up boards should be careful not to impose a listed company employee equity plan on a start-up.
In fact, as was mentioned at our recent Forum (see HERE), it may be best for a risk-taking and innovative start-up to have an equity plan unlike that of listed companies because of so-called “governance guidelines” on the listed companies.
Typically, these start-up and early stage growth companies have entrepreneurial founders, smart and enthusiastic employees, great ideas, but little cash. Both the founders and seed investors want to keep these employees and motivate them to grow the business.
The best incentive for these people is to have equity in the business – their wealth grows as they grow the business. They are risk-takers and prepared to back themselves and, therefore, want to share in the growth.
The problem for the founders is they generally find it so hard and costly to implement an employee share or option scheme – legal, tax, valuation, disclosure, accounting, leavers, vesting hurdles – and it goes on.
Directors of listed companies need to be assured they are investing in early stage companies with incentive structures that work for the company, its founders, employees, and investors and are without litigation risks.
The government and Australian Taxation Office (ATO) have started helping these start-up and early stage companies with some of the complexities of implementing an employee share scheme.
The ATO has released template documentation for certain eligible start-ups to draw from to implement an employee share option plan. These documents include:
- The broad outline of a set of Employee Option Plan rules
- A template for an Offer under an Employee Option Plan
- An instruction booklet for start-up companies on using the standard documentation
Considering the absence of assistance in the past, this is a good development
The ATO is continuing its consultation and should release further documents and templates before the end of the financial year. These include:
- Employee Share Schemes – employer’s handbook
- The broad outline of a set of Employee Share Plan rules
- A template for an Offer under an Employee Share Plan
- Employee share schemes for start-up companies – Employee handbook
Guerdon Associates has provided input to the consultation process that we trust has been useful (See ATO160303v2 ESS templates submission).
The material identifies all the issues – regulatory, disclosure, reporting, legal, tax, among others.
This material can reduce the complexity and cost for start-ups and, if adapted with proper guidance, can give the founders and directors of investing companies the assurance that the equity incentive structures are effective, legal and commercially motivating.
Proper guidance will leverage the template documentation and provide clarity and assurance on:
- The equity vehicle
- The participants – who, when and why
- The time of vesting and vesting scale
- The performance and/or service requirements, if any
- The good and bad leaver provisions
- Capital reorganization and bonus issue treatments
- Change in control provisions
- How and when board discretion should be used
- Meeting the information disclosure requirements
- Using the ATO safe harbor valuation methods
- Steering through the regulatory barriers
- The tax impacts for the company and employees
- The accounting impact for the company
- The reporting obligations
While large company experience on these matters can be useful, a start-up will have requirements that differ from larger listed companies. For example, a start-up will most likely provide options instead of the share rights used in listed entities. The options, being in lieu of cash salary, may have shorter and staggered vesting periods (e.g. monthly vesting, over a 12 month period). They will typically be contingent on service, but not on explicit performance requirements. Options will not typically be allocated on a fair value basis, but an absolute number which is the going rate for a job. This may not seem economically rational, but in a competitive job market for engineers with REST, Java, Node JS, or Python skills, you need to offer the same number of options as that received by the engineer she will meet at the start-up hub’s shared coffee machine. Grant frequency also needs to vary. It may be 6 monthly, plus additional grants on milestone achievements.
The ATO documentation for options is HERE.© Guerdon Associates 2022 Back to all articles