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Allow stock options or die

A successful start-up recounts how it managed to offer ESOPs even though the ATO frowns upon them.

A lot has been said recently about the need to nurture and encourage the local start-up scene in Australia. At all levels of government, we have seen attempts made to make Australia a more attractive proposition for homegrown talent to pursue their dreams.

Yet we are still seeing our best and brightest engineers and entrepreneurs seeking greener pasture in overseas start-up hubs, where conditions are more suited to fostering innovation and accelerating growth.

Eddie Machaalani and Mitchell Harper, Co-Founders and C0-CEOs of Big Commerce, a company that provides an e-commerce ...
Eddie Machaalani and Mitchell Harper, Co-Founders and C0-CEOs of Big Commerce, a company that provides an e-commerce platform for online businesses. Photo: Marco Del Grande

If Australia is to get serious about propagating the Australian start-up scene and hanging onto our homegrown talent, we need to think hard about leveling the playing field and how we can make things easier for local start-ups.

While there are a number of advantages that overseas start-ups currently have over their Australian counterparts, our failure to properly embrace Employee Share Option Plans (ESOPs) is to us the most glaring.

What's an ESOP? And why we (had to) have one.

When Australia was enjoying its coming of age party at the Melbourne Olympics in 1956, renowned American economist Louis Kelso was, at the same time, pioneering the ESOP.

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The fruit of Kelso's labour was an important landmark in the evolution of modern-day capitalism. In a broader sense, ESOPs became an economic driver for the super-charged US economy of the 20th century.

Essentially, ESOPs enable employees to buy stock in the company they work at and pay for that stock when they're sold at a future date. Not only do they allow the wealth generated by companies to be spread more evenly, but they drive amazing employee engagement and loyalty in the competitive world of start-ups.

And for start-ups, which know they can supercharge their growth by stacking their company with A-players (the top 5 per cent of talent in an industry), the power of the ESOP is even more potent. Little excites a talented software engineer like the knowledge that he or she will share in the fortunes of a company that their blood, sweat, tears and intelligence helped build.

From our perspective, maintaining an amazing company culture, fostering transparency, openness and valuing our team has always been a top priority. But, ensuring we hire the best people we can is equally important. From day one, it was obvious we needed an ESOP – timing was the only question.

This July, every one of our team members (all 170 of them) in the US and Australia became a stock owner of Bigcommerce. It was one of our proudest moments as founders.

Unfortunately there was a glaring obstacle we needed to overcome first – the same obstacle faced by all Australian companies hoping to roll out their own ESOP to employees.

Why aren't more Australian companies doing it?

In 2012, more than half a century since the notion of employee ownership was first realised, it is estimated that 28 million US employees participate in an employee ownership plan. That's about one fifth of the entire private sector!

In stark contrast, current estimates have ESOP adoption at about six per cent in Australia – well under the mark set by competing overseas economies.

  • Tax policy hitting entrepreneurs

So why, given the enormous advantage offered to companies, employees and the broader economy, have ESOPs been largely ignored to date in Australia?

Aside from forcing start-ups to spend an exorbitant amount of money creating a prospectus before they can offer shares to employees, Australia's taxation laws make things extremely tough. They lack intelligence and are needlessly conservative, discouraging the widespread adoption of ESOPs, especially among start-ups.

Their main weakness is that they treat purchased options like compensation for tax purposes as opposed to capital gains, meaning employees are required to pay a significant amount of tax during the same year as the options are purchased (prior to them being fully vested, or owned outright by the employee).

This means that, using a standard ESOP document in Australia, employees are hit with a major financial burden right off the bat, years before they're even able to exercise or sell the options.

For any Aussie company looking to roll out an ESOP, the thought they would have to ask their employees to cough up a large amount of cash upfront is completely ridiculous - imagine calling someone into a meeting to explain the situation. Good luck with that.

Using a standard ESOP document was never an option for us. In the US it's easy - there are standard documents that work for most companies. Not here though. So what did we do? We wrote our own.

How did we do it?

It was as much about common sense as it was financial wizardry from our CFO Robert Alvarez, who is based in our Austin, Texas office.

To overcome Australia's prohibitive tax laws, we decided to fund our employee option purchases using cash bonuses. Essentially, we pay a set amount to all of our team members to ensure they can purchase the options at market rate (as opposed to the exercise price).

For tax purposes, purchased options are given long-term capital gains treatment. They aren't treated as compensation. By ensuring the options were purchased at market rate, we were also able to ensure our employees would avoid immediate tax implications.

Buying the options at market rate also means our team members won't be taxed at each vesting period (the time at which their options convert into owned stock), as their options have already been fully exercised.

The net result is that our team members paid nothing out of their own pockets to purchase their options and will not pay tax for their options at any stage prior to an exit event (such as if we're acquired or if we become a public company).

Although it came at a significant cost to us, we were happy to fund this approach to ensure our team members could enjoy the benefits of an ESOP without being stung by the Australian Tax Office.

Our hope now is that other Australian start-ups seeking to implement an ESOP can take our lead, helping to make them more common in Australia - exactly how they are in the US.

For those start-ups that do, we advise them to set up their ESOPs early, when their valuations are lower. That way, the option price is lower and their employees will get to share in (hopefully) a bigger upside as the company grows through start-up and into maturity and then a market leading position.

A final thought

The Australian start-up scene is absolutely on fire. Every day a new disruptive company comes out and shakes up a stagnant industry, but this will only continue if the foundation of talent remains strong.

The power of ESOPs to attract and retain highly skilled staff, boost productivity and increase employee engagement can't be underestimated. Ultimately ESOPs are another weapon available to start-ups to help keep our prized talent at home where they can create and build new businesses – all of which is great for the Australian economy.

If regulators are too short-sighted and focused purely on increasing taxable revenue as opposed to letting businesses build value over time, then our start-up industry won't get anywhere near reaching its potential. We really can become the next Silicon Valley - the Australian Tax Office just has to reassess some of its policies.

(*) Mitchell Harper and Eddie Machaalani co-founded Bigcommerce.

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