Australia’s thriving startup ecosystem is built on innovation, agility, and attracting top-tier talent. With limited cash flow, startups often turn to equity compensation to align employees’ interests with long-term company growth. Two popular options—restricted shares vs options—offer distinct benefits, risks, and tax implications. This guide explores the nuances of both to help Australian startups make informed decisions about equity compensation.
What are Restricted Shares? Key Features of Restricted Shares in Australian Startups
What is Restricted Shares?
Restricted shares or deferred shares refers to shares granted to employees, typically founders or early hires—subject to vesting schedules and transfer restrictions. Unlike fully vested shares, employees earn ownership over time, with the possibility of forfeiture if they leave the company before completing the vesting period.
Key Features of Restricted Shares
Vesting Periods
Shares granted as restricted shares usually vest incrementally over time (e.g., over four years with a one-year cliff). Employees forfeit unvested shares if they leave the company early.
Taxation
In Australia, Employee Share Scheme (ESS) rules apply to restricted shares. The tax is typically triggered when shares vest, based on their market value minus any payment made by the employee. However, eligible startup companies can offer tax-deferred ESS plans where employees may defer tax until the earlier of several events including sale of shares or cessation of employment, up to a maximum of 15 years.
Liquidity Challenges
Even after shares vest, selling shares can be difficult, especially in private companies with limited secondary markets.
Employee Options: High Flexibility and Reward Potential
What Are Options?
Options give employees the right (but not the obligation) to purchase shares at a predetermined price (the exercise price) after a vesting period. If the company’s value increases, employees can buy shares at a lower price than market value.
Key Features of Options
Exercise Price
Set at the fair market value (FMV) when options are granted. As the company’s value rises, employees can exercise their options at a lower price and make a profit.
Taxation
Options are taxed when exercised, based on the difference between FMV and the exercise price. After 2022 ESS reforms, eligible startups can allow tax deferral until shares are sold, making share options more attractive.
Risk of Underwater Options
If the company’s valuation drops below the exercise price, share options can become worthless (“underwater options”).
Comparing Shares vs Options: Key Considerations
Restricted shares vs Options: Which Is Right for Your Startup?
| Factor | Restricted Shares | Options |
|---|---|---|
| Ownership | Immediate post-vesting. | Only after exercise |
| Tax Timing | Taxed at vesting (FMV taxed as income) | Taxed at exercise (gain taxed as income) |
| Liquidity | Limited by market availability post-vesting | Requires exercise and sale |
| Risk | Shares lose value if the company declines | Options expire worthless if FMV < exercise price |
| Employee Cost | Often minimal or nil | Must pay exercise price to acquire shares |
When employees receive shares under an Employee Share Option Plan (ESOP), they may be able to defer their tax obligations until they exercise the option and obtain financial benefits. This tax deferral can last for up to 15 years.
The point at which taxation occurs will be triggered by the earliest of the following events:
- The employee leaves the role associated with the acquired share rights;
- Fifteen years have passed since the rights were granted;
- There are no longer any valid restrictions on selling the rights, and there is no significant risk of the employee losing them; or
- The rights are exercised, and at that point, there is no significant risk of forfeiting the resulting shares, nor any genuine restriction on selling them.
Early-Stage vs Growth-Stage Considerations
Early-Stage Restricted Share Grants
At pre-Series A, Australian startups often issue restricted shares due to low valuations and minimal tax implications.
- Example: A startup valued at $5 million might grant restricted shares with a four-year vesting schedule and a one-year cliff. Employees own shares outright post-vesting, fostering loyalty.
- Tax Advantage: Employees can file an 83(b) election to pay taxes upfront on the nominal value of shares (e.g., $0.01/share), minimising tax liability if the company’s value rises.
Transition to Options Post-Series B
After raising a $50 million Series B, startups typically switch to share options (ISOs or NSOs) for new hires. This shift balances tax efficiency and dilution concerns:
- Valuation Alignment: Options are priced at the new FMV, reducing immediate tax burdens for employees. Example: A $50 million valuation might set an exercise price of $15/share, allowing employees to benefit from future appreciation.
- Tax Deferral: Unlike restricted shares, options are taxed only upon exercise, deferring tax obligations until a liquidity event (IPO or acquisition).
Real-World Example: Cake Equity’s Findings
Cake Equity’s 2024 report on Australian startups found 61% of employees value equity as a key motivator, yet many lack clarity on its worth.
- Early Employees: Receive restricted sahres at low valuations to minimise tax exposure.
- Post-Series B: Transition to options to align with higher valuations and attract talent without immediate cash costs.
Advantages and Disadvantages of Restricted Shares vs Options
Restricted shares Advantages
- Ownership Mentality: Employees immediately gain ownership after vesting, fostering loyalty and commitment to the company’s success.
- Tax Deferral Opportunities: ESS concessions can allow startups to defer taxes for up to three years.
- Simplicity: Easier for employees to understand compared to options.
Restricted Shares Drawbacks
- Immediate Tax Liability: Without ESS concessions, employees face taxes before they can sell or realise the value of their shares.
- Illiquidity: The inability to sell shares can make restricted shares less appealing in private companies.
Options Advantages
- High-Upside, Low Risk: Employees only incur costs if the company grows, making options a high-reward tool.
- Tax Timing Flexibility: The ability to defer taxes until the sale of shares for eligible companies makes options an attractive choice for many employees.
Options Drawbacks
- Complexity: Employees may struggle to understand the intricacies of exercise windows and tax implications.
- Dilution: Issuing new shares upon exercise can dilute existing shareholders’ ownership.
Legal and Compliance Essentials for Restricted Shares vs Options
ESS Compliance
Startups must comply with the ATO’s Employee Share Scheme guidelines, including disclosure requirements and ESS statements.
Securities Laws
Equity compensation offers must adhere to the Corporations Act 2001, ensuring startups do not offer unlicensed financial services.
Clear Documentation
Clear vesting conditions, forfeiture clauses, and termination rules should be outlined in offer letters and plans to avoid misunderstandings.
Recent Updates
The 2022 ESS reforms expanded access to tax deferrals for startups, simplifying the equity compensation process.
Making the Right Choice Between Restricted Shares vs Options
When choosing between restricted shares vs options for your startup, consider your company’s growth stage, valuation, and long-term objectives. Early-stage companies may find restricted shares an ideal solution, while growth-stage startups can leverage options for greater tax efficiency and employee engagement.
Final Tip: Partner with Australian legal professionals to ensure compliance with ESS rules and effectively manage the complexities of equity compensation. A well-structured plan not only attracts and retains top talent but also supports long-term business growth and success.
If you’re considering options or restricted shares for your startup, our team can help you structure the right equity plan.
