ESOP vs ESS: What Are They and What Are The Differences? (Updated 2023)

Launching a startup is an exciting and rewarding experience, but comes with many challenges – including attracting and retaining talented employees. Businesses need a dedicated and driven workforce to help propel them to success, but many companies face a talent drain during the crucial early stages of growth as most personnel stay only a few years before moving on to the next opportunity to advance their career or salary. 

Because most companies don’t have the financial resources to afford above market wages for their staff, one solution progressive startups have found is to incentivise and reward their early hires with employee shares or stock options. This can come in the form of an Employee Share Scheme (ESS) or Employee Share Option Plan (ESOP), both of which can help build a productive, more loyal, and committed team that aligns their personal goals with the company’s. 

If you’re considering adopting this practice in your startup, here’s what you need to know first.

What are Shares?

A share, also known as stock, is a unit of ownership in a company. Thus, an ESS grants employees with a piece of the company. As shareholders, the employees are entitled to a percentage of the capital and receive income as dividends (if the company pays them out).

For example, Fluffy PTY LTD has 100 shares divided between three owners: James, William, and Vincent. James has 75 shares, William holds 15 shares, and Vincent has 10 shares. If their company pays out $100,000 in dividends this year, James, as the 75% shareholder, will get a $75,000 dividend, William will get $15,000, and Vincent will receive $10,000.

Ordinary shares can also carry proportional voting rights. For example, if Fluffy PTY LTD needs to appoint a new CEO and holds an annual general meeting for shareholders, James, the majority shareholder, can outvote William on the decision. However, minority voting interests might be protected by a shareholders’ agreement – which companies adopt as a way to mitigate risks before they arise.

What are Options?

An option is similar to a contract that gives you the right, but not the obligation, to buy or sell a specific asset (usually shares in the company) at a specified price (exercise price) and within a specific time period (vesting date). The contract will expire if you do not exercise your right as the contract owner. 

The difference between ESS and ESOP

Both the ESS and ESOP are related to employee share ownership. However, they differ in meaning and implication.

Employee Share Scheme (ESS)

An Employee Share Scheme allows employees to purchase shares for the startup they are working for, usually at a discounted price. After purchasing the shares, they are given voting rights and the right to receive dividends like any other shareholder.

Employee Share Option Plan (ESOP)

As mentioned above, an Employee Share Option Plan is where employees are given the option (the right but not the obligation) to purchase shares at a specific time (vesting date) and at a predetermined price (exercise price).

When an option “vests,” the employee must either pay the exercise price or surrender their option. The exercise price is typically determined based on the fair market value of the shares at the time when the option was granted.

Once the employee has exercised their option, they will be issued their shares and will have both voting rights and the right to receive dividends like any other shareholder. 

Advantages of ESS and ESOP for employees

In March 2022, the Australian Tax Office (ATO) announced reforms that make it easier for startups to utilise ESS and reduce red tape. These changes include:

  • Amendment of disclosure rules, allowing unlisted companies to offer an unlimited number of shares of an unlimited value, so long as the employee is not charged more than $30,000 annually. Employees will also be able to accrue up to $150,000 over a 5-year period
  • For ESS not requiring payment for participation, independent contractors will receive the same treatment and regulatory relief as employees and directors who are also engaged in the scheme

Should employees opt to buy shares under the ESS, the taxing point for any options or shares granted will be deferred to the date when the share is sold. Simply put, employees will not be subject to upfront taxation. Since the ESS interest falls into the Capital Gains Tax (CGT) regime, the employee will not be obliged to pay taxes until the underlying shares are disposed of. This means there will be no income tax for employees:

  • At the time of grant
  • When options or shares “vest”
  • On exercise or disposal restrictions lifting

Employees will also be able to apply the CGT discount to any gains made between the time of grant and sale, provided they held the ESS interest for over 12 months. 

Advantages of ESS and ESOP for Startups

Employee share schemes and employee share option plans offer a number of benefits to your business. This includes:

  • Recruiting and retaining key talents
  • Encouraging employee innovation
  • Alleviating pressure on finances
  • Enhancing teamwork between employees and managers or directors
  • Improving job satisfaction

Disadvantages of ESS and ESOP for Startups

While the benefits outweigh the risks, implementing these practices still has some potential drawbacks. This includes:

  • Dilution of shares
  • Dip in share price performance
  • Running costs
  • Underperforming or resigning employees still holding equity
  • High buyback fees
  • Disputes and claims by employees

Key takeaways

Both the ESS and ESOP programs can be extremely beneficial to startups. However, since these require documentation and a formal written policy, you should never go the DIY route – it is always best to consult and hire a lawyer, as the risks are far too high when done incorrectly. 

Lazarus Legal has some of Australia’s most competent business lawyers and startup advisors and can help you implement an ESS or ESOP successfully. Let us help you find the right program for your startup, and let us work together so your business can enjoy impressive growth. 

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Mark Lazarus

Mark Lazarus, the visionary behind the business and the fresh blood of the Lazarus Legal team, Mark (or Laz as he is often known) owes much of his success to his past experiences. And he’s made it his personal goal to bring that wisdom and formula to the firm.

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ESOP vs ESS: What Are They and What Are The Differences? (Updated 2023)