Employee Share Option Plan

What Is a Employee Share Option Plan?

An Employee Share Option Plan (ESOP) is a scheme used by companies to give employees the right to buy shares in the company at a fixed price in the future. This fixed price is often called the exercise price or strike price. The idea is to align the interests of the employees with the success of the business. If the company grows and increases in value, the value of the shares goes up. The employee can then exercise their options, buying shares at the lower fixed price and potentially selling them for a profit.

In Australia, these plans are popular tools for startups and growth companies. They help businesses attract talent when they may not have the cash flow to compete with high corporate salaries. For the employee, it offers a chance to own a piece of the company they are helping to build.

It is important to distinguish an option from actual shares. Holding an option does not make you a shareholder immediately. You do not get voting rights or dividends until you exercise the option and the shares are issued. The plan document sets out the rules for how these options work, when they can be used, and what happens if an employee leaves the company.

When to Use This Document

Business owners typically use an Employee Share Option Plan when they want to incentivise staff but conserve cash. This is common in early-stage startups where cash is tight, but also in established businesses looking to retain key management personnel.

You should consider using this document if you are hiring senior staff who expect equity as part of their remuneration package. It is also useful when you want to create a culture of ownership across the wider team. By giving employees a stake in the future financial outcome, you encourage them to stay with the company for the long term.

However, an ESOP is not just for startups. Even small family businesses or professional service firms might use a form of equity compensation to reward long-serving employees. The decision usually comes down to a trade-off between paying higher wages now versus offering potential value later.

Before you implement a plan, you should ensure your company structure is suitable. Companies limited by shares are the most common entity type to use ESOPs. If you run a sole tradership or a partnership, you will need to restructure before you can offer shares or options.

You might also need a Deed of Accession. This is a shorter document that new employees sign to join the existing plan. It saves you from rewriting the main plan every time you hire someone.

Key Sections and Required Elements

A well-drafted plan must be detailed and legally precise. Australian corporate law is strict about how these schemes operate. Below are the essential sections you must include.

Definitions and Interpretation

This section clarifies the language used in the document. Ambiguity can lead to disputes, so clear definitions are vital. You must define key terms such as "Board," "Fair Market Value," "Option," "Participant," and "Vesting Date."

You also need to distinguish between a "Good Leaver" and a "Bad Leaver." A Good Leaver is usually someone who leaves due to illness, death, redundancy, or without cause. A Bad Leaver is someone fired for misconduct or who resigns without good reason. The definitions section should also explain the "Deed of Accession," which allows future employees to join the plan without changing the main deed.

Grant of Options

This section formalises the offer. It states that options are granted at the full discretion of the Board. It should specify the number of options granted, the exercise price, and the date of grant. It must also state that the grant is conditional on the employee signing the Deed of Accession.

It is best practice to include a clause that confirms the grant complies with the Corporations Act 2001 (Cth). This provides a layer of protection for the directors.

Vesting

Vesting is the process where an employee earns the right to keep their options. This section defines the service period required.

Industry practice in Australia usually follows a four-year schedule with a 12-month cliff. This means the employee earns nothing for the first year. If they stay past 12 months, they vest 25% immediately. The remaining 75% vests monthly over the next three years.

You should also define "Accelerated Vesting." This covers specific events where the vesting speeds up. Common triggers include a change of control, such as the company being sold, or the death or disability of the employee.

Exercise of Options

This section explains the mechanics of how an employee buys the shares. It must outline the procedure for giving notice to exercise, the method of payment, and the timeframe for doing so.

The "Exercise Window" is critical here. This is the period an employee has to exercise their options after they stop working for the company. Standard market practice often gives Good Leavers around 90 days to exercise vested options. Bad Leavers often forfeit unvested options and may have their vested options cancelled.

The document must state what happens if the employee does not exercise within the window. Usually, the options lapse and become worthless.

Adjustments

Companies change over time. They might split shares, consolidate them, or issue bonus shares. This section protects the employee's equity value during these corporate actions.

These are often called "Anti-dilution" or "Adjustment" clauses. They specify what happens to options if the company reorganises, merges, or there is a bonus issue. Without this, an employee could find their share of the company watered down significantly.

How to Write a Employee Share Option Plan (Step by Step)

Creating a compliant plan requires a systematic approach. While you can use templates, you must tailor them to your specific situation.

Step 1: Check Your Constitution

Before you write the plan, look at your company's constitution. Under Section 124(3) of the Corporations Act, the plan must be authorised by the constitution. If your constitution restricts issuing shares to employees, you must amend it first. This usually requires a special resolution passed by the shareholders.

Step 2: Determine the Eligibility Criteria

Decide who is eligible for the plan. Will it be for all employees or just senior management? If you want to rely on the disclosure exemption for startups, you must offer the scheme to at least 75% of permanent employees who have a tenure of less than three years. You cannot just offer it to the founders and the CEO if you want to meet this specific test.

Step 3: Set the Vesting Terms

Choose your vesting schedule. As noted, the four-year schedule with a one-year cliff is the standard. However, you might choose a different schedule based on your industry. Ensure the terms are written clearly in the document so there is no confusion about when options become vested.

Step 4: Establish the Exercise Price

Determine the price the employee will pay. This is a critical area for tax reasons. Options are usually issued "at the money" or "out of the money." This means the exercise price is equal to or higher than the current market value. Issuing options at a discount can trigger immediate tax liabilities for the employee, which is usually undesirable.

You may need a formal valuation to determine the fair market value, especially if you are relying on tax concessions.

Step 5: Draft the Plan Document

Draft the document using the key sections outlined above. Ensure you include the necessary warnings. Under ASIC Regulatory Guide 49, if you provide general advice about the scheme, you must include a "General Advice Warning." This warning must state that you have not taken into account the recipient's personal objectives, financial situation, or needs.

Step 6: Obtain Board and Shareholder Approval

Best practice dictates that the Board must approve the plan via a formal Board Resolution. If the plan creates a new class of shares or changes the rights of existing shareholders, you may also need shareholder approval.

Every individual grant of options should also be approved by the Board. This creates a clear audit trail and shows that the directors have fulfilled their duties.

Step 7: Issue the Deed of Accession

Once the plan is in place, you do not need to issue the full document to every new employee. Instead, you issue a Deed of Accession. This document refers to the main plan and contains the specific details for that employee, such as the number of options and the vesting start date.

Common Mistakes to Avoid

Many businesses make errors when setting up these schemes. These mistakes can lead to legal issues or unexpected tax bills.

Ignoring the Disclosure Exemption Rules

A common error is failing to strictly adhere to the requirements of Section 708A of the Corporations Act. This section provides an exemption from issuing a disclosure document like a prospectus. To qualify, you must meet specific tests.

For example, your turnover must be under $50 million, or you must be a startup incorporated less than 10 years ago. If you issue options to senior managers without ensuring they represent a small portion of the offers, you might lose the exemption. Losing the exemption means you have to produce a costly and complex disclosure document.

Failing to Distinguish Leaver Types

Not treating Good Leavers and Bad Leavers differently is a frequent oversight. If you allow a Bad Leaver, such as someone fired for fraud, to keep their options, it can demoralise the remaining team and damage the company. Ensure your document clearly defines the difference and the consequences for each.

Overlooking the Tax Warning

The Australian Taxation Office (ATO) takes employee share schemes seriously. Failing to include a clear Tax Warning is a significant risk. The document must explicitly state which tax regime applies, whether it is the Startup Scheme or the Standard Tax Scheme. You should direct the employee to seek independent advice. The difference in tax liability can be tens of thousands of dollars, and the employee may blame the company if they were not warned.

Poor Record Keeping

Equity plans create administrative burdens. If you do not track vesting dates, exercise periods, and share issuances accurately, you can end up with "ghost equity" on your register. This causes major problems during funding rounds or exits. Use a dedicated cap table management tool to track these details.

Using Equity to Undercut Wages

The Fair Work Ombudsman advises that ESOPs should be additional to the National Employment Standards (NES). You must not use shares or options to undercut minimum wage obligations or superannuation guarantee contributions. Ensure you are still paying employees correctly in cash.

Legal Considerations (AU)

Implementing an ESOP in Australia involves navigating several layers of law. You must consider corporations law, tax law, and employment law simultaneously.

Corporations Act and Disclosure

The primary legal hurdle is the Corporations Act 2001 (Cth). Generally, issuing securities requires a disclosure document. However, the Employee Share Scheme exemption in Section 708A removes this requirement for companies meeting the turnover or startup tests.

Even with this exemption, you must be careful. Under Section 688D, officers can be held personally liable if you provide a disclosure document that contains misleading or deceptive statements. Always ensure any information given to employees about the value or potential of the shares is accurate.

Taxation (Startup Scheme)

The Income Tax Assessment Act 1997 (Cth) governs the tax treatment of options. Subdivision 83A provides concessions for eligible startups.

To qualify, the employee must hold the options for at least three years. This defers the tax point until the employee sells the shares or ceases employment. There is also a potential 50% Capital Gains Tax (CGT) discount available. However, the total upfront value of shares or options granted to an employee in a year must not exceed $30,000 (indexed). If the value exceeds this cap, the concessions may not apply to the excess amount.

Financial Advice Warnings

Under the Corporations Act, providing information about financial products is considered providing financial advice. When you explain an ESOP to an employee, you are likely giving "general advice."

ASIC Regulatory Guide 49 requires you to provide a financial services guide or a general advice warning. You must state that the advice is general in nature and does not take into account the person's personal objectives. You should recommend they seek independent financial advice.

Employment Law

While the Corporations Act deals with the shares, the Fair Work Act deals with the employment relationship. You must ensure that granting options does not breach the National Employment Standards. Options cannot replace entitlements like annual leave or long service leave.

State variations are minimal for ESOPs specifically, as corporations law is federal. However, state-based industrial relations laws may apply if you operate in the non-national system, such as for unincorporated businesses in Western Australia. You should check your specific state industrial obligations if you are not a trading corporation.

Frequently Asked Questions (preview)

Do I need a lawyer to draft an ESOP?

While templates exist, the tax and legal implications are complex. A mistake in the drafting can invalidate the tax concessions or breach the Corporations Act. It is highly recommended to have a lawyer review or draft the plan.

Can I issue options to contractors?

Yes, you can, but the rules are different. Contractors do not count as "employees" for the 75% eligibility test in Section 708A. If you issue too many options to contractors, you might breach the disclosure exemption rules.

What happens to options if the company is sold?

This depends on the "Adjustment" and "Accelerated Vesting" clauses in your plan. Typically, options might accelerate, meaning they vest immediately, or they might be cashed out. The plan should clearly state the treatment of options upon a change of control or acquisition.

How is the exercise price determined?

The exercise price is usually the fair market value of the shares at the time of grant. For private companies, this is often determined by a board resolution using a reasonable method. If you are using the Startup Scheme tax concessions, getting a formal valuation is safer to defend the price to the ATO.

What is a Deed of Accession?

A Deed of Accession is a legal document that allows a new employee to join an existing Employee Share Option Plan. It means the employee agrees to be bound by the terms of the main plan without needing to sign the full plan document every time.