How many times have you heard horror stories of non-contributing or under-contributing founders (Non-Performing founders) retaining a large equity stake in the company?
Equally common are the stories of ‘simple’ fixes in the form of agreements to either:
- transfer the Non-Performing Founder’s shares (or a portion of them) at a nominal value to the remaining founder(s); or
- undertake a selective buy-back of the Non-Performing Founder’s shares (or a portion of them).
However, both give rise to risks around the market value substitution rules and the tax rules relating to the latter treat any amount not debited to the company’s share capital as a dividend (rather than a capital gain).
In this regard, prevention is better than cure and with a little forward planning founders may be able to avoid these issues by implementing a founder’s option plan at the outset or otherwise as soon as possible so that:
- they start off with the desired equity split;
- they are able to earn additional equity based on ongoing contributions to the business by setting vesting conditions whether:
- performance-based; or
- a combination of both; and
- the level of additional equity is such that by the end of the relevant vesting period, a Non-Performing Founder would be so significantly diluted that they hold a nominal equity stake in the company.
What is a premium-priced option plan?
First, we note that whilst it is commonly understood that a ‘start-up’ employee share scheme or employee share option plan (Start-Up ESS Tax Rules) are the most tax-effective plans under Australian tax law, founders generally hold more than 10% of the equity in the company and, therefore, neither:
- deferred taxation under Division 83A of the Income Tax Assessment Act 1997 (General ESS Tax Rules); nor
- the Start-Up ESS Tax Rules,
are available in these circumstances.
For more information on the General ESS Tax Rules and the Start-Up ESS Tax Rules – see here or check out our Start-Up ESOP Explainer Video here.
Secondly, a premium priced option plan (PPOP) is not a legislative term, rather, it is a term used to describe an employee share option plan where the exercise price of the options is sufficiently above the market value of the underlying shares on the grant date to deliver a nil market value for tax purposes such that:
- there is no discount provided in relation to the grant of the options; and, therefore
- there is no amount assessable to the employee participant under the General ESS Tax Rules.
They can also be used to deliver a nominal or low value for tax purposes.
The General ESS Tax Rules operate to tax employee participants on any discount they receive on the grant of an ESS interest (e.g., shares or options) and this discount is the difference between:
- the market value of the relevant ESS interest; and
- the consideration paid or payable for the ESS interest.
In relation to options, ordinary market value methodologies include the Black Scholes option pricing formula (as modified by Subdivision 960-S of the Income Tax Assessment Act 1997). However, the General ESS Tax Rules allow employee participants to adopt the market value under the tax regulations (where determine to adopt the value determined in the tax regulations in this regard (where applicable).
The Income Tax Assessment (1997 Act) Regulations 2021 (Regs) provide that an ESS interest that is an unlisted right (including an option) that must be exercised within 15 years of the grant date is, at the choice of the employee, either:
- the ordinary market value of the right; or
- the value worked out in the Regs (Regs Value).
In turn, the Regs Value is the higher of:
- the market value of the underlying share on the grant date less the lowest exercise price payable to exercise the right (Simple Value); and
- the value determined in accordance with the valuation tables in the Regs (Table Value).
The Table Value uses various inputs to determine an option value for tax purposes and, for example, other things being equal:
- the higher the exercise price above the market value of the underlying share on the grant date, the lower the option value and vice versa; and
- the longer the exercise period, the higher the option value (as there is a longer runway for the option to increase in value) and vice versa.
As outlined above, in these circumstances the rights (including options) must be exercised within 15 years, however, even if we take the maximum exercise period, the Regs specifically state that where the exercise price is more than 2x the market value of the underlying shares on the grant date, the rights have a nil value for tax purposes.
Further, if we wish to reduce the exercise price, we can perform a scenario analysis to determine the impact on the exercise price of reducing the exercise period, for example:
- if the exercise period were 4 years with an exercise price of $0.015 per option – the Table Value of the options is nil; and
- if the exercise period were 5 years with an exercise price of $0.015 per option – the Table Value of the options is just $0.000015 per option (which would be taxed upfront in the income year of the grant as deferred taxation is not available for equity holders over the 10% cap).
It is important to recognise that outside the Start-Up ESS Tax Rules, the holding period of an option does not count towards the holding period of the underlying share for the purposes of accessing the general 50% CGT discount.
This means that a founder under a PPOP will have to exercise their options and hold the underlying shares for at least 12 months after the exercise date in order to access the general 50% CGT discount (assuming all other conditions are satisfied) and this can be difficult where an unexpected exit occurs, however, there is always the possibility of:
- negotiating with a purchaser to acquire vested unexercised options for the relevant option premium (triggering CGT event A1 for the option holder and preventing them from ‘restarting the clock’ on the 12-month rule in relation to the underlying shares); or
- the company cancelling the options for the relevant option premium (triggering CGT event C2 for the option holders and preventing them from ‘restarting the clock’ on the 12-month rule in relation to the underlying shares).
Employee share options generally presents a clear bias in favour of exercising options as soon as they vest so as to ‘start the clock’ on the 12-month rule in relation to the shares, even though this means having to come up with the cash in order to fund the exercise price. However, if a PPOP has been designed to provide for the lowest possible exercise price as early as possible, it should not be difficult to come up with the nominal amount necessary to exercise the options.
Founders option plans are a great idea to ensure that Non-Performing Founders are appropriately diluted by those driving the business forward. It also is means that founders can avoid fighting over clawbacks and the potentially disastrous consequences of them.
As founders are generally above the 10% equity threshold for the purposes of deferred taxation under the General ESS Tax Rules and the Start-Up ESS Tax Rules, they will be taxed upfront on any discount they receive in relation to the issue of options. However, a PPOP can be designed to deliver a nil or nominal option value such that there will be no or nominal tax payable whilst achieving the desired commercial goals.
If you would like to discuss how you and your business could benefit from a PPOP, contact Mosaic Tax Legal at firstname.lastname@example.org or 1300 115 841