Reforming Employee Share Schemes for the good of start-up innovation

An effective employee share scheme would enable start-up companies to attract and retain the quality employees they need to become established successful ventures.

When the changes to Employee Share Schemes (ESSs) were announced in 2009, the measures were predicted by industry to result in less incentive for employees and greater administrative costs for companies, and subsequently result in companies turning away from the use of such schemes. It was feared that the changes, notably the taxing of shares upon issue instead of when a profit is realised, would undermine innovation in start-up biotechnology companies and there was a significant ground swell of opposition.

And so it was. Anecdotally, many start-up companies in the biotechnology sector reported grudgingly turning to alternative, less satisfactory, methods to retain, incentivise and reward employees.

In the months after the changes were implemented, AusBiotech spoke with key accounting firms, made a submission to the government in 2009 and began to advocate on behalf of its members - and continues to call for a repeal of the changes. This new burden on companies seemed to be aimed at the top end of town and had wrongly captured small, rapidly growing companies that often do not have the ability to reward employees with cash and so use shares and options as incentives and future rewards. AusBiotech supports a more sympathetic treatment of start-up companies, to support the growth of the innovative sector in Australia.

Most start-up companies are funded by means other than sales revenue, such as venture capital or share issues, and require those funds to conduct research and development and prepare a product to earn revenue. In this ‘cash pressed’ state they often rely on the support of ESSs to attract quality employees, and are an important support in enabling innovative start-up companies to establish. ESSs complement cash remuneration, making a salary package appear more substantive and attractive, in addition to the mutual benefit of giving employees a vested interest in the success of the company.

The importance of ESSs is especially poignant and amplified in the biotechnology sector, where the pre-revenue phase is typically extended by the need to clear regulatory hurdles before revenue can be earned - sometimes by more than a decade - and the cash required to reach regulatory approval.

Last year a Review of ESSs was instigated and concluded in February 2014. AusBiotech recommended to the review that taxing shares should occur at the time of liquidation/realisation, when market valuation is known, rather than at the time of issue, when value is uncertain.

Many employers in a start-up context cannot offer market salaries, so an ESS enables them to compete for appropriately qualified talent. ESSs in their pre-2009 form were effective as an incentive to lure and reward staff, with a relatively small cost to the employer - providing a ‘win-win’ situation. The employees have a vested interest in the company’s success and this sense of ownership often drives innovation and productivity.

An ESS works best as an incentive when tax is paid on success. If tax is charged pre-success or pre-gain, the shares come as a cost to the employee, with the tax payable before any value is generated. It is even worse when the share loses value, becomes worthless or is diluted when more shares are issued. This is comparable to paying income tax before you earn any income or paying tax in advance for an income that you may or may not receive. This method of taxation is a disincentive and disadvantages start-up innovative companies during the establishment and development phases.

Furthermore, the current situation of pre-gain tax means that companies must provide valuations of their capitalisation value, for use by the ATO. Biotechnology companies are notoriously difficult - and therefore expensive - to value. It is an inexact process, fraught with uncertainty. This requirement places a further, unnecessary, impost on start-up companies. There is no accounting formula that can achieve an accurate, reliable and fair valuation of pre-revenue start-ups.

The Australian biotechnology community needs a positive system for start-ups to encourage company creation. It is entirely appropriate for the Australian Government, and the Australian economy, to share in the prosperity of a capital gain, but only when it occurs.

Taxing at the time of liquidation - or realisation of a gain - is the only way forward for small innovation companies. It provides an important incentive for companies and employees and solves the issue of valuation. It also simplifies the administration from both the perspective of the ATO and from the issuing company.

Australia needs innovation to continue productivity growth and new industries to supplement and ultimately replace declining industries. If Australia’s tax system does not provide a conducive environment with competitive (comparable) incentives, these new ventures are undermined and Australia’s best ideas and the resulting economic benefits are then transferred to other countries.