5 common mistakes to avoid for your employee share scheme

By Director of Tax Services Jack Qi and Manager Alex Zinzopoulos

It’s fair to say that creating and maintaining an employee share scheme is outside the field of expertise of most startup founders. Because of this and the inherent complexity involved, we are often asked to resolve issues which, with a little discipline and diligence, could potentially have been avoided from the beginning.

1. Failing to ‘sell’ the employee share scheme

Whilst founders may be clear on the potential upside to employees and the generosity of what is being offered, too often the share scheme is not understood by the staff and as a result the desired alignment – the driver behind creating the share scheme in the first place – suddenly becomes elusive despite the best intentions.

To many programmers and engineers, the corporate finance concept of a share option may just be too exotic to understand without a helping hand. To the extent possible, companies should educate staff on what is being offered – whilst emphasising the need to obtain their own tax and legal advice.

2. Promises made but not actioned…. until now

We often have tech companies tell us that when they hired employee X, various commitments were made verbally but they simply haven’t gotten around to actioning them until now, at times years after the initial promise.

The problem is that in the intervening months or years, the value of the startup has grown exponentially and to issue the promised shares would result in a very large discount to market value, which can result in a significant tax problem for the staff. In addition, new investors would have come onboard and may not be aware of these commitments which may not be in line with their commercial expectations.

Upon being told of these hurdles, the startup then puts this into the too hard basket, which then only allows the problem to fester whilst the market value of the company continues to rise.

Our advice to startups is to action the promises on a timely basis, and do it in a way that avoids the next commonly seen pitfall…

3. Not obtaining tax advice or appointing a lawyer

Tax laws are complex. In our conversations with startups we often witness misconceptions and myths around how tax arises under an employee share scheme. The temptation is to simplify and generalise what is a complex problem, however with tax, the devil is in the detail.

The disclosure obligations under the Corporations Act are similarly complex and should only be advised by an experienced lawyer. To save legal costs, startups often use free templates available online for the creation of an employee share scheme. However, these templates typically do not address important terms such as good and bad leaver provisions; as well as matters like drag-along rights and power of attorney for voting interest of minor shareholders – which can unnecessarily hold up or sink a successful exit event.

Having a shareholder’s agreement and ensuring that all employee shareholders become a party to the agreement is a must.

To cater for everybody, templates usually adopt a ‘one size fits all approach’ that provides the company board powerful discretion on key terms such as amending the vesting criteria and accelerated vesting in an exit event.

Going back to the basic goal of alignment, an employee will only be incentivised and motivated if they feel they have something of value and they have a degree of control over that value. By leaving matters at the discretion of the board, the fundamental purpose of establishing an employee share scheme is undermined.

4. Over-complicating or being ‘too clever’ with the terms

Unnecessary complication can cause a lack of understanding amongst employees. This problem is compounded, as over time, they forget what was explained to them.

Similarly, if the terms are constructed in a way that undermines employees’ trust in the scheme, they will not value what is given to them – again resulting in failure to achieve alignment.

5. Failing administrative obligations

After an employee share scheme is established, maintaining it and meeting the ongoing requirements is another area we often see falling through the cracks. Common examples include:

  • ATO and employee annual reporting obligations not being met
  • Share and options register not being updated, causing founders to lose track of their own cap table
  • Failing to include employee shares/options in the payroll tax return, resulting in large unexpected payroll tax liability.

Want to know how to nail your startup employee share scheme in 5 steps? Read part one of this series

If you’re a startup looking for advice on the best way to approach an effective employee share scheme, contact your local advisor today.