With all of the hype surrounding the new employee incentive scheme tax rules, we thought it was timely to remind folks of a few key non-tax points about employee incentive schemes.
The first is that the issue of shares or options under an employee incentive scheme must still comply with Corporations Act disclosure requirements. The Corporations Act requires that any offer of shares or options must be accompanied by a disclosure document (such as a prospectus), unless an exemption applies. Common exemptions relied upon in order to issue shares or options to employees include:
- an issue of shares or options to senior managers;
- an issue of shares or options to no more than 20 persons in any 12 month period to raise no more than $2 million (disregarding issues to senior managers and issues that fall under other exemptions); and
- an issue of shares or options in reliance on CO 14/1001 (which is the class order ASIC has published to provide disclosure relief for employee incentive schemes where specified conditions are satisfied).
The conditions to the relief provided by CO 14/1001 have recently been relaxed (in anticipation of the tax-related changes that have now been implemented), but there are still some key requirements that must be met in order to rely on this relief:
- offers must be for fully paid voting ordinary shares, units in fully paid voting ordinary shares or options over or incentive rights that relate to fully paid voting ordinary shares;
- the above offers must be made for no more than nominal monetary consideration and, in aggregate, must not exceed $5,000 in value per participant per year;
- the issuer must have reasonable grounds to believe that the number of shares that have been or may be issued under the current offer, when aggregated with offers made under ASIC relief during the previous three years, do not exceed 20% of the issued capital of the issuer;
- the valuation of the offer must be calculated by reference to a directors’ valuation resolution, which also discloses the methodology for the valuation;
- a directors’ solvency resolution must be included in the offer document (which does not need to be as formal as a full prospectus); audited financial statements must be provided (if these have been prepared, or are required to be prepared under the Corporations Act) or otherwise a special purpose financial report is required to be provided; and the offer document must contain an explicit front page warning about illiquidity and realisation of value; and
- the most recent financial year’s audited financial statements or special purpose financial report must be provided within four months, to current participants on request.
A second important point is the 50 shareholder limit. Start-up companies may incorrectly assume that, because the requirement to convert from a proprietary company to a public company is triggered by having more than 50 non-employee shareholders, there are no consequences for having more than 50 shareholders generally. This is not the case. Once an issuer has more than 50 shareholders, the takeovers provisions of the Corporations Act apply regardless of the mix of employee and non-employee shareholders, meaning an acquirer has to make a takeover offer, or the transaction has to fall under an exception to that requirement, in order for a liquidity event that is a share sale to occur.
If a start-up company issues options to a number of employees that are exercisable in conjunction with a liquidity event, and all of those options are exercised on the eve of completion, the issuer may have more than 50 shareholders at the time of completion. A failure to comply with the takeovers rules can expose a potential acquirer to penalties under the Corporations Act. To avoid this risk, a potential acquirer would need to make a formal takeover bid (or use another structure regulated by the Corporations Act) and this can take months to complete and is much more expensive to implement than a typical exit. As a result, inadvertently breaching the 50 shareholder limit can have real costs (which are likely to be passed on by an acquirer as a reduction in the deal price) and can even discourage a potential buyer from engaging in a transaction at all. This is an expensive problem to rectify, so we would caution start-ups to ensure share plans and share and option grants are structured with sufficient flexibility so as to ensure this problem does not arise.
Also, companies should keep in mind, when issuing equity to employees, that there needs to be a way to get the equity back in the event the employee leaves – typically the company has buy-back rights, with the buy-back price differing depending on whether the person is a good leaver or a bad leaver, but remember that there are Corporations Act procedures that must be complied with in order to buy back shares. These buy-back procedures require statutory notice periods and shareholder approval, so care needs to be taken in the drafting of the equity plans to give the company the ability, in these circumstances, to be certain that the buy-back rights are actually able to be enforced. It is important to remember that there may be adverse tax consequences for the leaver if their equity is bought back by the company, including potential deemed dividends.
Finally, a popular question that we have been getting from start-ups is – what about all those flowering share schemes? Flowering share schemes were a popular way to deal with issues of equity to employees under the old tax rules. Flowering shares are essentially ordinary shares that have certain rights ‘turned off’ until an event happens that turns those rights on again. Because the rights are initially ‘turned off’, the shares are typically worth less than an ordinary share, and therefore it was possible to issue them at a nominal price that still represented fair market value (meaning shares were not issued at a discount, and therefore no tax was payable up front). Moreover, the shares were likely to be held for 12 months following issue, increasing the chances that the employee could access the capital gains tax discount. This largely eliminated or lessened the need for loan funded share schemes, where companies would provide non-recourse loans to employees to acquire shares.
In general, and subject to the terms of the individual plans, flowering share schemes still ‘work’ in exactly the same way as they were designed to – and may still provide a workable alternative where the company does not meet the eligibility criteria for the concessional start-up treatment under the new tax rules. A start-up may however still wish to re-examine its plan to see if there is any benefit to implementing a new plan under the new tax rules.