Written by Luke Musto, Associate
The initial launch of a startup can happen very quickly. Ensuring that it becomes successful, however, can be a much longer process.
Every founder will need to be able to attract skilled and driven team members in order to make their startup successful. The reality for most early stage startups, however, is that they will not have the budget to be able to offer competitive salary packages to their initial hires, who will likely be the people critical to the long-term ongoing success of the company. So how do startups attract and retain key employees with limited funds? Many startups, and particularly tech startups, will solve this problem by offering equity for their initial hires.
What is equity?
This type of arrangement, also known as ‘sweat equity’, means that a worker will provide labour to the business in exchange for equity. In practice, means an employee will accept a lower salary than would typically be expected for a comparative position in exchange for shares or options over a period of time.
From the startup’s perspective, this can reduce initial salary costs until the business has grown to a point where it can afford to pay employees higher salaries, while at the same time allowing the startup to remain competitive in attracting high-quality employees. It also gives employees a direct incentive to work hard in order to ensure the startup’s success.
From an employee’s perspective, they are agreeing to an initial lower salary for the opportunity to own shares that they expect will increase in value. In the long run this may mean that they will end up earning more money, recognising their key role in the success of the startup.
What are the key benefits?
Using an equity scheme provides several benefits to both startups and their employees. These include:
- Recruitment and retention of talented employees: a rewarding scheme will be an attractive incentive for potential employees, and encourage them to stay with the company for the long-term.
- Increase in shareholder value: the interests of employees will be directly aligned with those of other shareholders and the company, ensuring employees remain motivated to work for the success of the company in order to grow their own holdings.
- Alleviation of cash flow pressure: businesses are able to offer benefits to top personnel without straining their finances.
- Creating a sense of ownership: As employees gain a sense of ownership in their work, it encourages them to work as a team with management and can bring a level of happiness, in turn boosting job contentment and productivity rates.
What are a startup’s options for equity?
There are three main types of equity schemes that startups can consider. There are key differences between the schemes, and it is important that founders choose the right scheme for the needs of their startup.
- Employee Share Scheme (ESS)
Under an ESS, the startup will issue the employees with shares. These shares are typically vested over a period of time, so that if an employee leaves the startup before all their shares are vested, the company will automatically have the option to repurchase them. The Australian Tax Office (ATO) offers tax concessions to companies and employees, provided that they meet eligibility criteria. Companies that opt to use an ESS must comply with certain rules, including that:
- Workers must pay no less than 85% of ordinary market value upfront (subject to exceptions);
- Ordinary shares must be issued;
- The shares must vest for a period of three years or more;
- Workers cannot hold more than 10% of shares; and
- The company must offer shares to 75% or more of its Australian residence permanent employees who have at least three years experience with the startup.
For many startups, these conditions will often be very restrictive, particularly because many startups will only wish to issue shares to certain key employees. In particular, for startups with a pool of global talent then this type of scheme may not be an option. Furthermore, in the event that vesting conditions are not met, the company must undertake a selective buy-back, which can be a complex process.
- Employee Share Option Plan (ESOP)
ESOPs are structured agreements to give employees partial ownership of the business via options to acquire shares in the company (as opposed to outright shares). Similarly to ESSs, certain ESOPs will be eligible for tax concessions from the ATO. Unlike ESSs, there are no participation requirements, and the startup is able to distribute to as many employees as it wishes. Given that most people are less familiar with the concept of share options as opposed to shares, employees will likely also require more education on options and what this means, particularly in relation to not receiving dividends or holding voting rights.
- Shares subject to vesting
Finally, employees may also be issued with shares that are neither ESS nor ESOP. Under this option, a contractual agreement is made between the employee receiving the shares and the company. This is used for instances where a startup wishes to issue more than 10% of its shares to an employee. Shares will vest over a period of time (typically four years), and if the employee leaves before this period, they will only receive the benefit of the shares that have vested (for example, typically if they leave during the first year they will receive no benefit at all). This is similar to ESS and ESOPs, in that it both incentivises employees to stay with the business for the period of the agreement and protects the business in the event the employee leaves.
Impact on Employment Law Obligations
It is important to note that equity arrangements do not impact on the minimum employment entitlements set out by the National Employment Standards (NES). As long as they are employed, workers are entitled to the minimum wage and associated benefits. In addition, startups should consider whether employees are covered by an award. It is important that startup founders are familiar with the NES and their employment law obligations.
There are many famous stories of employees being issues with shares from startups only to become millionaires as the company later sees success – this is the case with giants such as Apple and Google. Equity schemes allow companies that may have limited cash flow to still attract top-tier talent, and offers the opportunity for such employees to share in the success of the company. Given they can be somewhat complex arrangements, it is important that both startup founders and employees understand exactly what is involved.
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