Pricing Startup Options, a Common Mistake

This article is not legal advice and does not take into account your individual circumstances. Always seek professional advice in relation to the matters discussed.

Start-ups that have introduced Employee Share Option Plans (ESOP) are all too often pricing the strike price of shares at arbitrary price points, such as the last capital raising value, without due consideration of the relevant commercial and legal framework. Start-ups should be aware of the pricing flexibility for ESOP shares and should use pricing to achieve their aims.

The issues

Australian tax law suffered long standing criticism for failing to address the unworkable situation whereby start-up employees may be liable for tax on value that they don’t have and may never get. Previously, an option issued to an employee that was not paid for at market value created an untenable situation whereby the value of the option may be taxable in the hands of the employee. Clearly, if issuing an option to an employee results in the employee having to pay tax up front and the employee is aware that their shares may never be valuable, it would be difficult to incentivise employees with equity.

Start-up communities in Australia called for the Turnbull Innovation Reforms to bring Australia into line with other jurisdictions that have introduced means of dealing with this issue. In this context it is surprising that time and time again start-ups fail to make use of safe harbour pricing regulations.

Flexible pricing

Effectively, qualifying start-ups can now issue options to employees for a discount or nil consideration, subject to a number of conditions. One of these conditions is that the exercise price (or strike price) for the shares must be greater than or equal to the market value of the share at the time the option is issued. By Legislative Instrument — Income Tax Assessment (Methods for valuing unlisted shares) 2015, the Commissioner has approved market valuation methodologies that can be used to calculate this market value.

There are two accepted methods of determining market value, neither of which necessarily relate to the value of the start-up at its last capital raise. If the start-up has not raised more than $10 million during the period of 12 months before the valuation, the ‘market value’ of a share may be calculated (in summary) by taking the amount of net tangible assets of the company and dividing it by the number of shares on issue. If the company is a tech start-up with almost no tangible assets, it is easy to see how this method may result in market value being a price that is far less than the price paid by an investor.

If the start-up has raised more than $10 million during the period of 12 months before the valuation, the market value must be determined by a valuation carried out by the CFO of the company or a suitably qualified valuer. Given investors often purchase preference shares that may be several times more valuable than ordinary shares issued under a startup option, it is again likely that the market value of the option shares would be substantially lower than the price paid by an investor.

So what does this all mean? if you’re a start-up, it is likely that you are able to price your option shares at a much lower price than investors have paid and you may have a large amount of flexibility on pricing. I have been asked before whether it is a ‘bad look’ to price option shares at below the price an investor has paid, given that in effect you are saying that the market value is less than the price paid by the investor. The simple answer to this is — no. The Innovation Reforms were introduced, in part, so that start-ups could incentivise employees by giving them valuable rights without adverse tax consequences, use them! Any sophisticated investor will understand the reasons for this and will understand that the legislative pricing mechanism and definition of ‘market value’ may not necessarily reflect the market value of the shares.

Commercial considerations

Once aware of pricing flexibility, it is important to understand the commercial considerations. When choosing a strike price, the company needs to be aware of its goals. It should ask: is the option (a) a reward for past performance; or (b) an incentive for future performance. If the option is a reward for past performance, it may be fair to price the shares at below the price shares are currently being bought and sold for. The rationale here is that if the employee helped to raise the value of the company, the strike price for their shares should be tied to an earlier valuation of the company so that the employee could theoretically sell their shares for a profit today and would share in the uplift in company value from an earlier point in time. Conversely, if the employee is a new employee, you are likely to want to set the strike price at the same price as shares are currently being bought and sold for so that the employee shares in the value uplift from that point in time.

Companies may also want to reduce the strike to make options more valuable if, for example, you are looking for ways to make your offer to a new employee more compelling and don’t have the cash reserves for a larger salary. Then again, you may want to raise the strike price to the highest justifiable value given that this is the amount that will eventually be paid to the company and, choosing the last raising value is unlikely to raise any questions. The considerations are infinite and whatever your motives, companies should be aware of the flexibility they have and should use it to achieve the outcomes they seek.

So remember, when it comes to pricing your options at ‘market value’, market value may not mean what you think it does and you may have more flexibility than you expect. Consider your intended outcomes and price accordingly.