ESOPs: A Founder's Guide to Sharing the Pie
As a founder, you're building something special, and you want your team to share in the success. Employee Stock Option Plans (ESOPs) are a fantastic way to do just that. They're not just about giving away equity; they're about attracting, retaining, and motivating top talent.
What are ESOPs, really?
Think of ESOPs as a promise. They give your employees the option to buy shares in your company at a set price (the grant price) in the future. If the company does well, and the share price rises above the grant price, your employees can buy shares at the lower price and potentially profit. It's a win-win: they're incentivised to help the company grow, and they get a piece of the pie.
Why should you care?
ESOPs are a powerful tool for founders. They help you:
Attract the best: Top talent wants more than just a paycheck; they want ownership. ESOPs make your offer more competitive.
Retain key employees: Vesting schedules encourage employees to stick around for the long haul.
Boost morale: When employees feel like owners, they're probably more engaged, productive, and invested in the company's success.
Preserve cash flow: Particularly valuable for early-stage startups when cash resources are constrained and better deployed towards product development and market expansion.
Australian Tax Benefits: The Start-up Concession
If you're operating in Australia, there's excellent news. The Australian government introduced the Start-up Tax Concession in 2015 specifically to help startups incentivise employees with equity ownership whilst managing the tax burden.
How the concession transforms tax treatment
Under the standard tax rules, employees would typically face a significant tax burden upfront—being taxed on the discount value of options as if it were part of their annual income, even though there's no liquidity in those options yet. With Australia's highest individual marginal tax rate currently at 47% (inclusive of all levies), this creates a substantial barrier.
The Start-up Concession changes everything:
For employees:
No upfront tax: Employees are only taxed when they sell their shares and realise an actual financial benefit—not when options are granted or exercised.
Capital gains treatment: Any gain is treated as a capital gain rather than income, which is significantly more favourable.
50% CGT discount: If employees hold their shares for at least 12 months, they can access the 50% Capital Gains Tax discount, effectively halving their taxable gain.
Timing from grant: The CGT discount period starts from when options are granted, not when they're exercised—meaning the holding period clock starts ticking immediately.
For companies:
Reduced administrative burden: Employee annual reporting to the ATO is not required (though minimal ESS reporting is still required in the year options are granted).
Competitive advantage: The tax benefits make your equity offer significantly more valuable to employees.
Flexibility: You can still offer other types of employee share schemes alongside the start-up concession.
Eligibility requirements
To qualify for the Start-up Concession, your company must meet these criteria:
Company requirements:
Less than 10 years old (from incorporation)
Not listed on any stock exchange
Annual aggregated turnover of less than $50 million
Australian resident taxpayer (the employing entity must be Australian)
Employee requirements:
Hold no more than 10% of company equity or voting rights
Currently employed or contracted by the company (or a subsidiary)
Equity structure requirements:
Must be ordinary shares or options over ordinary shares
For options: exercise price must be at or above the market value of shares at grant date
For shares: offered at market value or with a maximum 15% discount
Must be held for at least three years (or until the employee leaves the company, whichever comes first)
What if you don't qualify?
If your company doesn't meet the Start-up Concession criteria, there are alternative structures available, including:
Tax deferral schemes: Defer taxation until vesting, exercise, or sale
Loan-funded share schemes: Can still produce tax-effective results
Zero exercise price options (ZEPOs)
Premium-priced options
Each has its own merits and compliance requirements, so professional advice is essential.
Key things to remember
ESOPs can be complex, so here are a few founder-friendly tips:
Get professional help: Talk to lawyers and accountants who specialise in ESOPs and Australian tax law. They can help you design a plan that's right for your company and maximises the available tax benefits.
Choose appropriate valuation: Use ATO-approved valuation methodologies (professional valuation, recent capital raise, or Black-Scholes model) to set defensible exercise prices.
Keep it simple: Communicate the ESOP clearly to your employees, including the tax benefits they'll receive. Transparency is key.
Think long-term: Your ESOP should align with your overall company strategy and growth plans.
Consider vesting structures: Common approaches include cliff vesting (e.g., 100% after 12 months), graduated vesting (e.g., 25% annually over four years), or milestone-based vesting.
Plan for exit events: Include provisions for accelerated vesting in circumstances like acquisition, merger, or IPO.
Stay compliant: Be aware of ongoing obligations including ATO reporting, payroll tax, workers' compensation reporting, and Corporations Act disclosure requirements.
The Australian advantage
According to recent data, Australian startup employees exercise their options at a rate of 51.8% compared to 32.2% in the United States, and Australian founders reserve a median of 12.6% fully diluted equity for employees. This demonstrates a strong pro-ownership culture where equity is seen as tangible rather than symbolic - and the Start-up Concession is a key driver of this culture.
Final thoughts
ESOPs are an investment in your company's future. Done right, and structured to take advantage of Australia's generous tax concessions, they can be a game-changer for attracting and retaining the talent you need to reach your goals. The combination of tax efficiency, alignment of interests, and wealth creation potential makes these arrangements attractive to both companies and employees - creating a true win-win scenario.