Given the critical importance of attracting, retaining and incentivising key talent to the success of a startup, the merits of employee share and options schemes are well-accepted within the tech sector.
It has become almost obligatory for startups and scaleups to set aside 10-15 percent of their cap table for an employee share or options scheme. If this isn’t done, investors will often ask why, or even list the creation of an employee share scheme as a condition of their investment.
However, despite its ubiquity, we often see tech companies run into the same set of challenges or mistakes – which limit the effectiveness of the scheme at best and create a legal, administrative and tax mess at worst.
In this two-part series we build upon the basic concepts in our earlier discussion and aims to provide practical ‘do’s and don’ts,’ to make the most out of an employee share scheme and avoid the common pitfalls.
The fundamental ‘why’ of creating an employee share scheme
At the forefront of every founder’s mind when making any decision about an employee share scheme should be the reason for creating one in the first place – In our view it should be to create alignment between the best interests of the company and the self-interest of employees.
Often, in our experience, founders forget this when ‘going through the motions’ of creating an employee share scheme ‘because they have to.’ Instead, they must focus on creating a win-win.
The best share plans share the fruits of success in a generous (but measured) manner rather than create an adversarial negotiating environment.
How to nail your startup employee share scheme in 5 steps
1. Clear vesting criteria that provide certainty to employees
To achieve alignment in company interest and employee self-interest, employees need to feel in control of the vesting of their shares/options. We are commonly asked what an appropriate vesting criterion is, and we usually suggest time-based vesting due to its simplicity and the presumption that if the employee continues to be hired by the company they must be delivering on their KPIs.
For example, 25 percent vesting after a one-year ‘cliff’ and vesting of the remainder on a quarterly basis over the next three years is a commonly adopted approach in Australia.
On the other hand, for specific roles such as sales and business development, using more specific performance criteria is not uncommon.
2. Good and bad leaver provisions that drive the right kind of behaviour
In the dynamic world of startups, employees moving on is a fact of life. Therefore, an employee share scheme must clearly spell out what happens to the shares/options when someone leaves the company under various conditions.
Usually, vested shares/options of ‘good leavers’ may be kept by the employee or bought back at fair market value, whereas ‘bad leavers’ have theirs cancelled or redeemed for minimal consideration.
But how do you distinguish between good and bad leavers?
This is where we advise companies to refer back to the fundamental ‘why’ discussed above. For example, consider what do you wish to happen in the following contrasting scenarios, whereby the employee:
- Is leaving to join a competitor
- Leaves due to reasons beyond their control (e.g. health)
- Is made redundant
- Is dismissed for misconduct.
3. Option exercise price that befits the situation
Where the employee share scheme uses share options, a common question we come across is what to use for the option exercise price – i.e. the amount an employee must pay to turn their options into shares. The two most common exercise price used by startups are:
- Market value of a share at option grant date – this essentially enables the employee to benefit from the future upside in the capital value of the shares
- As low as possible (subject to tax requirements) – this is where founders maximise the value of the options for employees.
While both of the above are commonly adopted, the approach that’s right for your startup depends on the facts and circumstances – for example, consider whether the employees are paid below-market salaries. Also, honour what was promised to staff when they joined the company.
Clearly, setting a low exercise price sends the best message to employees and if that’s the decision a startup should do its best to make employees aware of the generosity of the offer.
4. Accelerated vesting in a change of control
When a startup succeeds and gets acquired, what happens to the unvested shares/options? Potentially, they could:
- Vest immediately
- Be replaced with shares/options in the acquirer (but this cannot be anticipated in advance)
- A combination of the above, subject to board discretion.
In the interest of alignment and assuming the exit event is a sign of success, the startup should generally allow for at least some of the shares/options to vest immediately in an exit.
5. Tax effectiveness
Last but not least, how an employee share scheme is structured will affect the post-tax benefit employees receive. An employee share scheme that creates a tax headache for staff is counterproductive and has no reason to exist. Because of the illiquidity of their shares, startups should generally aim to achieve two things for staff:
- Defer the taxing point as long as possible
- Create access to the 50 percent capital gains tax discount.
Due to the way our tax laws work, there is often a trade-off between these two outcomes. However, an options scheme under the generous ‘Startup Concessions’ potentially allows for the best of both worlds. Accordingly, unless there is a very good reason to pursue something different (or the eligibility criteria cannot be met), this should be the starting point for most startups and scaleups.
In the event this concession is not available, other alternatives exist. Examples include:
- Options with a ‘real risk of forfeiture’ and deferred taxing point
- Limited recourse loan shares schemes
- Options with a premium exercise price (and are therefore valued at nil for tax purposes)
- ‘Flowering shares.’
Click here to read part two