Australia’s new employee stock ownership plan disclosure exemptions present a stark choice

New reforms designed to expand access to employee equity and reduce red tape by removing disclosure and other regulatory requirements will come into force in October – but the reality is they will present companies with a stark choice when offering equity in Australia to employees.

The final weeks of Australia’s 46^th Parliament saw the passing of much heralded reforms to the rules impeding the ability of private companies to offer equity to employees to commence on 1 October 2022.

Employee equity can be critical for high growth startup and scale-up companies. Being able to offer equity to employees enables a company to close the gap with cash salary packages offered by mature corporates, align interests and motivate employees as part-owners of the company and encourage employee retention through vesting.

But regulatory limits on offering equity in Australia without a disclosure document, like a prospectus, can make employee equity a scarce resource.

High growth companies can rapidly outgrow statutory allowances that limit exempted offers to senior managers, employees who are certificated to meet sophisticated investor income or assets thresholds or “small scale offerings” capped at personal offers to no more than 20 recipients in any 12 months. Special purpose alternative disclosure exemption pathways for employee equity were still paperwork-heavy and subject to financial caps and/or had limited application. All of this leads to a rationing of employee equity to the most critical and senior resources.

Australian startups have looked to their Silicon Valley peers - where employee equity is a mainstay of the startup community and a key attraction to working in it - and wished they, too, could reward more employees with more equity for the backing their company by providing an opportunity to share in the company’s potential success.

The bottom line

For option plans, the choice for companies under the new reforms will be:

1. offering zero exercise price options under the new exemptions that have light touch regulation but are unlikely to be eligible for the startup tax concessions (so Australian employees will pay tax on the value of the option at exercise as income, rather than as a discount capital gain); or
2. offering options which require payment on exercise, which are eligible for the startup tax concessions, but which must be offered:

• under a prospectus (or potentially under an offer information statement), or
• under one of the existing equity disclosure exemptions (which are often inadequate), or
• under the new exemptions for employee equity which are complex and more heavily regulated than the previous employee equity exemptions, imposing new liability (for any misleading or deceptive or out of date information in offer documentation), leading to more costs and risk for the company and its officers.

The new exemptions replace the current cap of $5,000 p/a per person on the value of the options with a cap on the amount paid by the employee in relation to the options of $30,000 p/a per person (which, to the extent unused, may be aggregated for up to 5 years ie to $150,000) plus 70% of any cash bonus and dividends paid to the employee in the year. This is in effect an ‘expenditure cap’.

The new exemptions also permit more non-employee participants to participate in employee incentive plans.

Implications for Australian Startups

While the new Corporations Act ESOP exemptions will provide additional pathways, many startups and scale-ups will have to make a choice for Australian ESOPs between offering employee equity with more attractive tax treatment and a broader employee equity offering that is less financially attractive over the longer term. Some companies may opt for different plans for different groups of employees (eg one for senior managers or participants who have a qualifying accountant’s certificate, whose offers do not require disclosure) and a “zero exercise price” option plan for others.

Despite the less favourable tax treatment, zero exercise price options can be attractive to some employees as the later tax benefit can be more difficult to understand or value compared to the “free shares” they receive from the options, with some degree of certainty of value assuming the share price does not go to zero. If the exercise price of options is fair market value (usually referable to the latest raise price), the intrinsic value of the options based is zero or low and the value for the employee relies on the company’s value increasing after the grant. This can diminish the trade-off for the employee of comparing 'guaranteed' value vs preferable CGT tax treatment.

Ultimately companies will need to weigh up – and potentially trade off - the burden of disclosure and liability and risk under the new exemptions, the financial appeal of the tax concessions and the way they want to position their employee equity offers to their Australian employees in order to attract and retain talent.

Overview of the new rules - option plans

The new rules commencing on 1 October 2022 will treat disclosure requirements for employee options very differently depending on whether or not the participant has to pay money on either the grant or exercise of the options.

Zero exercise price options

If the company takes zero payment from the participant for the options, offers after 1 October 2022 will be very lightly regulated, with no prospectus or short form offer document required, and no ASIC lodgements or valuations required, provided that the offer is expressed to be made under the new rules.

Zero means zero - a nominal exercise price and/or an ability to “cash out” in a liquidity event to pay the exercise price would be regarded as the employee making a payment.

However, a plan offering zero exercise price options means that Australian participants are unlikely to be able to rely on ESOP startup tax concessions, particularly if their company has raised more than $10 million in capital in the prior 12 months.

This means the value of the shares will be taxed at income tax rates following exercise and lifting of any sale restrictions. Participants will pay more tax, and this may be a significant amount. Although, depending on the ultimate sale price, they may be better off being granted zero exercise price options than options with an exercise price equal to the market value of the ordinary shares.

Options requiring payment

One requirement for employee incentive options to qualify for the ESOP startup tax concessions is that the exercise price must be based on the market value of ordinary shares. If option grants qualify for the startup concessions, Australian tax-resident participants will only be taxed at sale on the value of the shares less the exercise price as a capital gain and eligible for the 50% CGT discount (assuming the options are granted at least 12 months prior to sale). Companies eligible for the “safe harbour” valuation methodology may also be able to determine the market value of ordinary shares based on net tangible assets less outstanding liquidation preference which may result in a low or even nominal exercise price.

But offers of options that require payment (even a low or nominal amount and even if the participant can utilise a “cashless exercise" so making no net payment) will continue to require a prospectus unless a disclosure exemption applies.

From 1 October 2022 the available exemptions for employee incentive options for private companies will be:

New exemptions

The new exemptions contained in the Corporations Act allow offers of options to be made without a prospectus where the offer and the options meet certain conditions. 

These conditions include the ‘monetary cap’ which imposes a maximum of $30,000 payment per year per person (which if unused may be aggregated up to 5 years ie to $150,000) plus also 70% of any cash bonus and dividends paid to the participant in the year. This cap ceases to apply if a ‘liquidity event’ (eg an IPO) occurs and some payments are permitted to be made (if held in a trust account) 7 days before the liquidity event but companies and participants may find that narrow window to exercise and make payment difficult to administer in practice and the constraints attached to those options will need to be factored into the transaction structure.

However, offers under these new exemptions are more heavily regulated than has been the case for the employee equity exemptions they are replacing, as they are more complex and impose new liability on the company and its officers under the terms of issue in relation to any misleading or deceptive or out of date information in the documentation provided in relation to the offer, leading to more costs and risk for the company and its officers. And if a company relies on the new exemptions, the loan, contribution plan and trustee requirements will also apply to offers that use the small scale offering exemption. To rely on the new exemptions, companies will need to review and amend their Plan rules and template option offer documents so that option terms of issue comply with the requirements of the legislation, including incorporating relevant protections under the Corporations Act. Companies will only be able to rely on the new exemptions for options offered, marketed or granted on or after 1 October under compliant terms of issue.

Assuming the company works through these hurdles, the liquidity event timing and monetary cap conditions under the new exemptions will create additional challenges. The 5-year cap on aggregating the $30,000 p/a payment limit could result in scenarios that constrain or impact particular transaction structures or require complex analysis at the time of a liquidity event. These kinds of scenarios may be able to be managed leading up to an IPO or other liquidity event but create risk and uncertainty for participants in the meantime.

Existing statutory exemptions

The usual exemptions under the Corporations Act will continue to apply, however, it is expected that ASIC will consult soon on sunsetting the ASIC Class Order 14/1001 exemptions which have allowed the issue of options up to a cap on the value of the option of $5,000 per year per participant) provided that certain conditions including regarding disclosure and ASIC lodgements are met.

The existing exemptions also include a qualifying accountant’s certificate certifying that the employee meets the sophisticated investor criteria, small scale offerings (raising up to $2 million in any rolling 12 months from personal offers to no more than 20 people), senior managers and minimum $500,000 exercise price, but the Australian Law Reform Commission is currently undertaking a review in relation to these ‘wholesale client’ exemptions and proposes that they are simplified and amended and has foreshadowed raising the bar for ‘wholesale client’ qualification.

The shorter form Offer Information Statement (OIS) will continue to be available under the Corporations Act as a disclosure alternative to a prospectus. This is a more simplified and streamlined disclosure document than a prospectus but is capped at $10 million raised. From 1 October an OIS can be used for options plans by proprietary (Pty Ltd) companies in addition to share plans. An OIS also has financial reporting and lodgement requirements that can be more difficult to meet or make timing problematic when compared to prospectus requirements. These including lodgement with ASIC of a 12-month audited financial report current within 6 months before the first securities offered under the OIS and prepared in accordance with the accounting standards and other requirements of Chapter 2M of the Corporations Act, even if the company is not otherwise subject to those provisions.