Significant changes to the ESOP rules are here…
An employee share option plan (ESOP) is a scheme which grants employees of a company the right to purchase or be issued shares in the company. Over the past few decades, ESOPs have increasingly formed a significant part of the total remuneration package for executives and are largely seen as “par for the course” for most early-stage companies looking to acquire talent before they can pay for it with cash. ESOPs are designed to improve staff retention, incentivising employees to stay and grow together with the company.
Significant changes introduced to amend the rules governing ESOPs took effect on 1 October 2022 and while there was a grace period allowing offers to be made under the old regime, this expired on 31 March 2023. It is important for all businesses with ESOPs in place, or those considering a new ESOP, to be across these changes as they represent a fundamental shift in the approach to disclosure and the risk profile for the team involved in promoting the schemes.
Underlying the reforms seems to be a relatively simple policy perspective: where the participant does not need to pay anything, there is little to no downside risk and therefore little regulation. Where the participant pays, you either need to provide disclosure or rely on an exemption.
What’s changed?
Recent legislative changes have amended the rules around ESOPs, in particular relevant disclosure requirements. Previously, ASIC Class Order CO 14/1000 for listed companies and CO 14/1001 for unlisted companies provided relief from various provisions in the Corporations Act 2001 (Cth) (Corporations Act). However, on 1 October 2022, new legislation took effect to replace the old regime and offers made from 31 March 2023 must comply with the new regime.
At a high level, the key changes are as follows:
disclosure relief for offers for no monetary consideration – companies offering interests under an ESOP for no consideration – that is, no cash or other consideration leaves the participant’s hands at any stage, are not required to make substantive disclosure. As a result, so called “zero exercise price options” – effectively free options which often can’t be exercised until a liquidity event occurs – have risen in popularity but require delicate drafting;
substantive disclosure for offers for monetary consideration – where offers under an ESOP require the participant to pay cash or other consideration either on grant or on exercise, substantive disclosure obligations will apply. In addition, these offers are subject to:
an issue cap (the default is 5% of a listed company’s securities and 20% of an unlisted company’s securities, both subject to the company’s constitution which should be updated at the next available opportunity for companies looking to issue more than the default issue cap) which limits the number of shares a company can offer, plus a complicated monetary cap ($30,000 per annum in addition to 70% of any cash bonus and dividends paid to the participant in that year, albeit there is an ability to aggregate for up to $150,000 over 5 years) that limits the total amount that a participant can pay for their options;
prescriptive offer and supporting documents (including financial statements); and
an ongoing requirement to update information which is either incorrect or becomes out of date.
In practice, the disclosure requirements under the new rules are strict and may be challenging to satisfy for businesses without a dedicated finance team and sophisticated reporting function.
Who is impacted?
The changes are important and you should be thinking about these changes if:
you have an existing ESOP, in which case you should be thinking about whether your current scheme is compliant; or
you are thinking about introducing an ESOP, in which case you should be thinking about how to set up your ESOP to ensure that it is compliant.
Existing ESOPs
For those businesses that already have an ESOP in place, the grace period is up.
As mentioned earlier, ASIC Class Orders CO 14/1000 and CO 14/1001 previously provided relief from provisions in the Corporations Act. While existing grants issued before 31 March 2023 still have the benefit of relief under CO 14/1000 and CO 14/1001 (provided the company is complying with all of the requirements, including the need to issue ASIC with a “Notice of Reliance”), new grants must be compliant with the new regime.
From our experience, most ESOPs which were put in place before late 2022 are not compliant with the new rules. In many cases, it is more efficient to simply put a new scheme in place than to try and fix the old rules. In some cases, only light changes need to be made to the plan rules whereas the offer documents will require a significant re-draft.
New ESOPs
If your company is considering implementing an ESOP for the first time, the first point for your consideration is whether an ESOP is right for your business. There are both benefits and drawbacks in setting up an ESOP. We explore them below.
The chief benefits of an ESOP include:
providing an alternative or supplementary incentive for the team (in comparison to traditional incentives such as bonuses), particularly for early-stage companies where cash may be tight;
creating a natural mechanism by which the team can participate in and benefit from an exit event;
creating an environment where the team feel like they own a part of the business, improving accountability of outcomes;
allowing the leadership team to talk more openly about all staff having a stake in the business; and
being a good way of rewarding tenure and loyalty to the business whilst helping improve retention of key executives.
Depending on the structure of the plan, the main drawbacks of an ESOP can include:
the cost to set up the plan and additional administrative costs to maintain the plan (although offers for no consideration may now be less expensive to implement and maintain);
the potential to create conflict of interests for employees when the business strategy does not align with any performance targets in the ESOP (if it is not purely tenure-based);
requirements for extensive and ongoing communication, especially for broad-based schemes across the business; and
employees focusing too much on equity value (leading to demotivation when share prices fall, particularly in a listed environment where the share price is constantly in view).
At Tiger & Bear Partners, we have helped many companies explore the benefits and drawbacks of ESOPs, and where it makes sense, helped implement compliant schemes working alongside the tax experts.
What’s next for my business?
As noted earlier, the new laws are live and offers can no longer be made under the old regime. For businesses with an existing scheme, they may continue to rely on the previous class order relief for grants under ESOPs made before 31 March 2023, but any new grants will likely require a refresh of the plan rules and offer documents. For businesses looking to implement an ESOP for the first time, there is no choice – the new rules apply.
If you choose to go down the path of ‘no consideration’, there are significantly less disclosure requirements under the new rules. While attractive from a regulatory perspective, if you consider that ‘offers for consideration’ are better suited for your business, then it is important to ensure you fully understand and comply with the new disclosure and other requirements outlined above (and that is just the tip of the iceberg). In our experience, it’s also critical to work with an experienced tax adviser to ensure that the tax consequences for both the company and the participants are fully understood at the outset.
Please reach out to our team if you would like any assistance with either creating a new ESOP for your business or updating your existing ESOP to ensure that it is compliant with the new rules.