Valuing employee stock options under the new rules – has the ATO got something right?

There’s been a lot of press about the new Employee Share Scheme (ESS) rules, due to the problems created by the old rules.

The element that created the biggest tax problem was the value placed on each share or option, and the speed with which that could change.

Let’s say you raised $500K, at a pre money valuation of $2m, post of $2.5m. The purpose of the $2m number is to figure out the % of the company the new investor would own, in this case 20%.

If you wanted to allocate 5% to a key staff member, at post money valuation of $2.5 this is $125,000. Unless they “bought” the shares, in practice they would have a taxable income of $125,000. You can do the maths on why that’s a problem. The solution used required very experienced (and very expensive) lawyers and tax advisors.

As part of the new rules, the ATO has released their method for valuing unlisted shares or options. As a member of the finance profession I never thought I’d say this, however for many startups they may have got this right. I’m reserving final judgement on that for now.

The valuation method they’re using is something called “NTA”, which is an accounting term for Net Tangible Assets.

How do you figure this out? Make sure your accounts are up to date, then look at your balance sheet. Remember liabilities or debts (such as amounts owing in superannuation) are your best friend in this case, so make sure all of those are in. Not sure what this means? Ask your accountant.

There’s a number towards the bottom called “Net Assets”. That’s your starting point.

If your accountant has “capitalised” your product development (taken it out of costs and moved it to the balance sheet), then you can remove that asset as it’s considered an “Intangible Asset”.

Hence Net Tangible Assets = Net Assets – Intangible Assets

This then becomes the “post money valuation” number you use to figure out how much your shares or options are worth. If you’re an early stage company, chances are it’ll be a lot less than $2.5m.

So what’s the catch? There’s always a catch. Are you eligible?

I can’t give you tax advice, but what I can say is if you meet all of the following, then go ahead and use the online ESS plan schemes appearing at the moment, setting it up as an options plan:

  • Is the company employing the staff member Australian? (is it registered with ASIC)
  • Is the company private (does it have Pty Ltd in the name)?
  • Do all of your investors (including their related entities) own less than 40% of the company each? For example, if you have an investor who’s got shares personally, plus through a family trust, add the two % together.
  • Is your revenue less than $2m in the last 12 months?
  • Have you been incorporated for less than 7 years?
  • Have you raised less than $10m in the last 12 months?
  • You’re not planning either an exit or major capital raise in the next 6 months, where you’d sell more than 40% of the company?
  • For any of the people getting shares or options, will they own less than 10% of the company once it’s done.
  • Will the employee options convert to Ordinary shares, once exercised?
  • Do you expect that your staff will hold the options for at least 3 years?

If you don’t, all is not lost. You may still get the benefits related to the new rules, which will make life much easier, it’s where a good tax advisor will add the most value for you.