Employee Share Schemes: A complete guide for Australian Businesses

Employee share schemes have become essential tools for Australian businesses looking to attract top talent and retain key employees. But with complex legal and tax considerations, many business owners struggle to implement these schemes effectively.

In this comprehensive guide, we explore everything Australian business owners need to know about employee share schemes, from the basics through to implementation strategies that actually work.

What Are Employee Share Schemes?

Employee share schemes are arrangements that give employees a stake in the business they work for. This can happen through:

• Direct shares - actual ownership in the company

• Options - the right to buy shares at a predetermined price in the future

• Phantom shares - profit-sharing arrangements that mirror share ownership without actual equity

For tech companies and high-growth businesses, offering some form of equity compensation has become standard practice. Employees expect it, investors often require it, and it's become a crucial tool for competing in today's talent market.  For other businesses, employee share plans have become a commonly used tool for long term talent retention, albeit often limited to a core group of employees.

Why Australian Businesses Use Employee Share Schemes

Business owners typically implement employee share schemes for several key reasons:

1.      Talent Retention and Attraction

When you can't compete on salary alone, equity compensation helps attract and retain top performers. It's particularly effective for senior management positions where the right hire can significantly impact business growth.

2.      Sharing the Mental Load

Many business owners find themselves carrying the entire burden of business success. By giving key employees a genuine stake in the outcome, you create partners who share your commitment to the business's success.

3.      Preparing for Succession

Employee share schemes can be the first step in transitioning ownership to the next generation of leaders within your business.

4.      Incentivising Performance

When employees have skin in the game, their performance often improves dramatically. They start thinking like owners rather than just employees.

Employee Share Schemes vs Share Options: Which is Right for Your Business?

Direct Share Ownership

With direct shares, employees become actual shareholders with immediate ownership rights. This approach works well when:

• You want employees to participate in dividend distributions

• You're comfortable giving employees voting rights

• You're planning a gradual transition of ownership

• Your business generates consistent cash flow

However, direct share ownership can create complications when employees leave, and it's more difficult to adjust or revoke if circumstances change.

Share Option Plans

Options give employees the right to buy shares at a predetermined price (the exercise price) at some point in the future. This approach is often preferred because:

• Easier to manage departing employees - Options can be cancelled if someone leaves

• No immediate shareholder rights - Employees don't receive voting rights or dividend claims until they exercise their options

• Simpler exit scenarios - In most sales, vested options are just cancelled and the difference between the exercise price, and sale price of a share, is paid out

• Better control - You maintain full control of the business until options are exercised

The main downside is that option holders don't receive dividends, which matters more for cash-generating businesses than high-growth companies focused on capital appreciation.

How Much Equity Should You Allocate?

There's no one-size-fits-all answer, but here are some common approaches:

1.      Startups

Typically allocate 10-15% of total equity to an "option pool" that gets distributed to employees as they join. However, this pool often gets exhausted quickly with key hires.

2.      Established Businesses

The percentage depends heavily on business valuation. A $100 million business will find it difficult to give a senior employee 2% (worth $2 million), while a $5 million business might comfortably offer that same percentage.

Key Considerations

• Business size and valuation

• Employee seniority, contribution, term of employment and loyalty factor

• Industry standards

• Your long-term ownership goals

• Available funding for any loans required

Funding Employee Share Purchases

One of the biggest practical challenges is how employees actually pay for their shares, especially in valuable businesses.

Loan-Funded Plans

The most common solution is for the business to lend employees the money to buy shares. Here's how it works:

1. Business values shares at $1 million

2. Employee borrows $1 million from the business

3. Employee immediately uses that $1 million to buy the shares

4. Employee still owes $1 million to the business

If the business later sells for $3 million per employee's shareholding, the employee keeps $2 million (the profit) and repays the $1 million loan.

Limited Recourse Loans and Dividend Funding

Some companies let employees buy shares using a loan from the business. These are usually ‘limited-recourse loans,’ which means if the shares lose value, you won’t have to pay back more than they’re worth.

Often, the loan can be repaid gradually from dividends. However, there are some tax rules to be aware of—like Division 7A and fringe benefits tax—which can affect how the loan and dividends are treated. It’s important to get advice so you know exactly how this might impact your personal tax and your businesses’ tax obligations.

Managing Employee Departures

One of the most complex aspects of employee share schemes is handling departures. Most plans distinguish between "good leavers" and "bad leavers":

Good Leavers

• Made redundant (not their fault)

• Left due to illness or disability

• Sometimes includes voluntary resignation (depending on plan design)

Bad Leavers

• Terminated for cause or misconduct

• Sometimes includes voluntary resignation

Vesting Schedules

Most plans include vesting schedules that determine how much of an employee's equity they "earn" over time. Common structures include:

• 25% per year over four years (time-based vesting)

• Performance-based vesting tied to specific KPIs or business milestones

• Combination of time based and performance-based.

Good leavers typically keep their vested equity, while bad leavers may forfeit both vested and unvested portions.

Tax Considerations for Australian Businesses

Employee share schemes interact with virtually every tax in the Australian system:

For Employees

• Income tax on any discount received when shares or options are issued

• Capital gains tax when shares or options are eventually sold

• Potential for CGT discount if shares or options held for more than 12 months

For Employers

• Fringe benefits tax considerations

• Payroll tax implications

• Division 7A issues if lending to existing shareholders

• Reporting obligations

Startup Tax Concessions

Eligible businesses can access special tax concessions that make employee share schemes more tax-effective, but strict eligibility criteria apply.  These concessions were targeted towards startups, but can be used by most businesses who are less than 10 years old and who have less than $50 million in aggregated turnover. 

Implementation Process: Getting Started

Step 1: Define Your "Why"

Before diving into structures, clearly articulate why you want an employee share scheme:

• Retention of specific individuals?

• Sharing the management burden?

• Preparing for succession?

• General employee motivation?

Step 2: Determine Scope

• How many employees will participate?

• What percentage of equity will you allocate?

• Will this be ongoing or a one-time arrangement?

Step 3: Choose Your Structure

Based on your objectives, decide between:

• Direct shares vs options

• Voting vs non-voting rights (noting there may be tax implications which arise as a result)

• Dividend participation

• Vesting schedules

Step 4: Get Professional Advice

Employee share schemes intersect corporate law, tax law, and employment law. The cost of getting it wrong often far exceeds the cost of proper professional advice upfront.

Common Pitfalls to Avoid

1.      Inadequate Documentation

Poor documentation leads to disputes later. Ensure clear plan rules, offer letters, loan agreements, and where necessary, shareholders' agreements.

2.      Tax Mistakes

Getting the tax treatment wrong can create enormous problems for both the business and employees. This is particularly complex for businesses with overseas employees.

3.      Overseas Employees

Each country has different laws and tax treatments. What works in Australia may create significant problems in other jurisdictions.

4.      Unrealistic Expectations

Manage employee expectations carefully. Many employee share schemes create disappointment when employees see owners receive millions while they receive thousands at exit.

5.      Inadequate Communication

Use equity as a motivational tool by sharing relevant business updates, valuations, and progress with scheme participants.

Success Stories and Lessons Learned

Well-designed employee share schemes can transform businesses. Employees with equity think differently - they worry about costs, focus on revenue, and take ownership of problems.

However, success requires careful balance. Some business owners voluntarily reduce their sale proceeds to top up employee payments, recognising that employee contributions were essential to the business's success.

The key is setting realistic expectations upfront and ensuring the scheme genuinely reflects the contribution employees make to business value.

Phantom Shares: An Alternative Approach

Phantom share schemes provide the economic benefits of share ownership without actual equity. Employees receive bonus payments calculated as if they owned shares, including:

• Participation in sale proceeds

• Potential dividend-equivalent payments

While popular overseas, phantom shares are less common in Australia because our tax system generally allows for tax-effective employee share schemes with actual equity.

Getting Started: Working with Professionals

Implementing an employee share scheme requires expertise across multiple disciplines. The process typically involves:

1. Initial consultation (1-2 hours) to explore objectives and options

2. Strategic planning to design the optimal structure

3. Documentation including plan rules, agreements, and tax elections

4. Ongoing management of vesting, departures, and scheme administration

Costs vary significantly based on complexity:

• Simple startup option plans: $5,000-$7,000

• Complex multi-tier schemes: $15,000-$30,000+

• Enterprise-level plans: $100,000+ for large businesses with hundreds of employees

Key Takeaways for Australian Business Owners

Employee share schemes can be powerful tools for business growth, but they require careful planning and professional implementation. Key considerations include:

• Start with a clear understanding of your objectives

• Choose between shares and options based on your specific circumstances

• Plan carefully for employee departures

• Get tax advice early in the process

• Manage employee expectations throughout

• Consider the long-term implications for your business structure

When implemented correctly, employee share schemes align employee interests with business success, creating a more motivated workforce and often significantly improved business performance. Employee share schemes are becoming less of a nice-to-have and more of a business necessity. The key is getting the structure right from the start.

For more on employee share schemes from a legal perspective, listen to our podcast episode with Darren Sommers, Principal at Adventum Legal. With his combined background in law, science, and IT, Darren shares practical insights on structuring schemes, managing tax implications, and avoiding common pitfalls.

This article provides general information only and should not be considered legal or tax advice. Always consult qualified professionals when implementing employee share schemes for your business.