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    • nikhil@smartlife.nz

      Business Owner

      @nikhilsmartlife-nz

      Issuing new shares for employee share scheme

      Question submitted 16/09/21 @ 07:17am

      How do you all see this working without having tax implications straight away for the employees? We are a start-up looking at launching an ESOP scheme by issuing new shares (diluting other shareholders or do you think the founder should lose some of his equity and use his personal shares for ESOP - Ideally we don't wish to dilute the founder ). We know we can start with a loan scheme to employees so the tax is applied when the company is sold ( no recovery from employees if the company liquidates) But when you issue new shares, do you issue them to the founders (does that mean the founder has to pay tax on the newly issued shares?) and then roll the shares scheme from founders equity ( thus founder shares are not reduced) Any help (without costing arm and leg) would be appreciated.

      Category: Legal
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      • Andrew Hamilton

        Admin

        @andyadmin

        Reply submitted 16/09/21 @ 07:17am

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        Morena – there are a bunch of questions there, let me see if I can answer them
        – ESOP schemes normally (employee share ownership schemes) start after the company has been founded and are a way of sharing some of the future upside with key employees and sometimes all employees
        – they have become much easier to implement these days
        – the typical version is that a company that has 100 shares, decides to allocate 5% 10% or 15% into a ESOP pool for employees, so that means (basically) that the share capital of the company increases by that amount eg. 105, 110 or 115 (there is a wierd math formula which means it is not quite that number) and you authorise this through a shareholders resolution approving the increase in share capital and also typically the ‘rule’s of the ESOP scheme ie how it will work, and who is authorised to issue Options to employees and advisors
        – note, at this point, no options have been issued, more the rules for the scheme are established
        – then the actual terms of any issue will include things like the exercise price, the length of the term of the option, the vesting term ie how do options get allocated over what period of time, and things like good leaver, bad leaver
        – for a worked example say we are issuing 5 options to a person in the team, the options may have a 10 year term, the exercise price maybe $1 per share and the 5 options vest over 5 years ie 1 option per year – the person does not have to do anything now, it is just a right to buy a share in the future, but lets say we get to year 5 and all options are vested and lets say then the share price is $100 per share (happy days) – if the employee exercises the options (normally because the company has been sold) then what happens is they would pay $1 per share for the 5 options, and they would have to pay tax on the increase in market value of the share from $1 to $100 ie tax on the $99 – now this is ok, if the company has been sold as it is just a net-net and it is fair to pay tax because they were granted these as part of employment
        – there are other ways to structure but this way is the simplest and you know, you really can’t avoid things like death and taxes!
        – for founders, they don’t have the tax issue, because they did not get the shares in the course of employment (yes I know it is slightly wierd)

        Re your questions:
        – dilution is part of live, like death and taxes, when an ESOP is issued, everyone gets diluted, including the founder – that is my personal view, I don’t like friction of saying ‘no the founder should not be diluted’
        – loan schemes are used and can work, they require more legal upfront costs, the key question will be ‘is there a benefit that the employee has received in the course of their employment’ which is taxable and who pays that – if the Company wants to pay the tax impact ‘early’ rather than later, then I think this is good, but someone has to pay the tax man!
        – generally keeping it all in one set of shares is easier, rather than separate compartments

        Hope this helps – it feels to me like I rambled. I need coffee now. Hammy

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        • nikhil@smartlife.nz

          Business Owner

          @nikhilsmartlife-nz

          Reply submitted 16/09/21 @ 07:17am

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          Thanks Andrew, that makes sense

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      • Averill Dickson

        Business Owner

        @averill-dickson

        Reply submitted 16/09/21 @ 07:17am

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        Hi Nikhil

        ESOP schemes usually involve issuing options, not shares. It is only when the option are exercised and convert to shares that a taxable event occurs.

        When an ESOP pool is created, this is usually an allocation on the cap table that is neither “real” shares nor options. The effect of this is that the dilution affects all existing shareholders equally. However, if you are bringing in new shareholders, and you don’t have a current ESOP allocation on the cap table, they may require that an allocation be made so that their incoming shares are calculated as if the full ESOP pool had been issued – the effect of this is that ESOP shares up to the allocated amount only dilute the existing shareholders, not the incoming shareholders. And if the full ESOP allocation is not actually issued, the incoming shareholders get a windfall.

        We generally do not recommend loan schemes, except in very limited circumstances. They are expensive to implement, poorly understood by employees, and there is very little ability to structure these in a way that creates tax advantages (the tax man has plugged many holes relating to these over the years).

        We have a number of ESOP guides and templates on our website, see:

        https://kindrik.co.nz/guides/startup-company-guide/#esops

        https://kindrik.co.nz/guides/esops-in-nz-cap-tables-and-company-records/

        https://kindrik.co.nz/guides/esops-in-nz-board-and-shareholder-approvals/

        https://kindrik.co.nz/guides/how-to-calculate-your-esop-pool-shares/

        The last one above also explains the weird maths formula that Andy mentions above, and has a spreadsheet tool to calculate this.

        If you’d like to have a chat with one of our lawyers on this, we offer a free half hour initial consult. Just submit a contact request at https://kindrik.co.nz/contact-us/ and an appropriate person will get back to you.

        Cheers

        Averill

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        • nikhil@smartlife.nz

          Business Owner

          @nikhilsmartlife-nz

          Reply submitted 16/09/21 @ 07:17am

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          Thanks Averill. I will look through your online resources

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