Ask yourself: would you accept a job offer if the employer was offering you half your market salary, an upfront tax bill, and a punt on the future value of company shares three to five years out with only a 5% chance of success?

We need to stop thinking of Australia’s innovation industry as an island. It is instead a small pool of high-quality talent that will hop across the pond if we don’t do everything we can to attract and retain it. In some areas we need to ensure we’re ahead of the game in terms of supporting an innovation industry, but in other areas we need to act fast  just to match the baseline in other markets. One example of the latter is addressing the tax treatment of employee share options for early-stage tech startup ventures in Australia.

Why is there a tech startup brain drain?

Australia’s startup community is increasingly mobile — the move to cloud storage and processing for many technology platforms means the founders of a new tech startup venture need little more than an airfare, a visa and a laptop to relocate to whichever global destination offers the most attractive business environment for establishing their business.

In the past, Silicon Valley has been the major destination for startup founders due to the large and well-funded community there. However in the past decade competitive startup communities have been established in several other major US cities (LA, New York, Chicago, Boulder, Las Vegas, Austin) and in several major international cities (London, Berlin, Singapore, Tel Aviv, etc). Like in Australia, these startup hubs are increasingly supported by a community of early-stage investors, mentors and service providers.

While Australia enjoys a significant quality-of-life advantage in attracting the best global startup entrepreneurs, we face several disadvantages too:

  • Very high cost of living;
  • Relatively isolated and expensive to travel from/to if customers and markets are primarily overseas;
  • Small, under-developed seed stage and venture capital ecosystem; and
  • Relatively unfavourable tax treatment for investors, founders and employees.

Employee Share Option Scheme (ESOP) reform

In most countries, ESOPs are used as a cost-effective way to motivate and reward the early-stage employees who will make the biggest difference in developing a new tech startup, while at the same time reducing the cost of employee compensation to cash-poor tech startup businesses.

Under an ESOP, employees are granted share options they can “exercise” or “strike” to buy stock in the company at a future date based on the current share price. Because successful tech startups enjoy significant capital growth, the difference between the sale price of the granted share and the exercise price of the ESOP stock option can produce a significant windfall for the employees participating in the ESOP. Employees are retained by making a proportion of the total ESOP grant available over time, typically in a series of annual tranches over three, four or five years.

It’s important to note that ESOP schemes are not without their risks and costs.

For the employee, ESOP options are granted as part of a compensation package featuring a salary significantly lower than their current market rate. The employee balances the salary foregone against their ability to contribute to the market value of the company, which in turn may provide a return when share options are exercised.

For the employer, ESOP schemes can be expensive to establish and maintain. If the future share price drops below the strike price, employees may be demotivated rather than motivated by remaining with the company.

Australia’s tax treatment of ESOP equity makes ESOPs almost completely impractical to setup and administer, and makes them difficult to offer as a means of attracting and retaining key talent.
Currently employees granted ESOP share options in Australia are taxed on receipt at the market value of the underlying share. For instance, an employee granted 10,000 options to purchase shares in 12 months time at a strike price of $0.10 is considered by the ATO to have received a taxable benefit of $100,000.00 and tax is payable in the tax year the options are granted.

This is inequitable because the employee owes tax immediately, and yet is unable to earn anything from exercising the 10,000 share options for another 12 months, and even then, will only receive a benefit if the shares they receive are worth more than the $0.10 strike price.

A tool meant to motivate and retain employees in other markets actively demotivates employees in Australia because instead of receiving a benefit, the employee receives an immediate and significant tax debt, without any assistance to bridge the gap between tax owed and the potential and uncertain future profit on the sale of ESOP shares.

It’s important to remember that the odds of Australian employees seeing a profit from the sale of ESOP shares are low — the 2012 Startup Genome report on the Australian startup industry found that fewer than 5% of Australian startups went on to achieve success.

This article was originally posted on CeBIT

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