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Employee share ownership: Impediments and solutions
Share option schemes are probably the preferred structure for start-up companies. These schemes provide employees with the benefit of share price increases without exposure to losses if the company does not succeed. They are also well-recognised internationally in the context of companies with high growth potential.
The two areas where law reform may assist are securities law and tax. Currently, both areas contain features that are less than optimal when it comes to facilitating the operation of share option schemes by start-up companies. This makes it harder for start-ups to compete in the global marketplace for people with the talent to be innovators.
Securities laws are designed to protect investors by requiring any person offering securities to the public to make disclosures that will enable investors to fully understand what they are buying. These disclosures take the form of a detailed registered prospectus and a more user-friendly investment statement.
In some cases, for technical reasons, it is uncertain whether these requirements will be triggered by an offer of share options to the employees of a start-up company. Concerns about this can impede or prevent start-up companies from establishing the share option arrangements that they see as desirable to attract, retain and motivate key employees.
There is a strong case for a general exemption making it clear that share options may be offered to employees without the need for a prospectus/investment statement. This is on the basis that employees are not normally required to pay for their options (i.e. none of their own funds are put at risk) and, at least in a start-up context, are fully aware of the speculative nature of the options. Given these factors, it is not important for employees to receive a prospectus and investment statement when the options are issued.
The position is different at the point in time when options are exercised because, when this occurs, the employee actually invests in the shares and assumes the usual shareholder risks. For this reason, policymakers may consider that full disclosure is necessary before options are exercised. Various mechanisms are available to start-up companies to deal with such a requirement, such as only permitting exercise if the option gains are sufficient to justify the production of a prospectus/investment statement.
The other area in need of reform is tax. Under current rules, employees are taxed at the date of option exercise on the difference between the amount they pay for the shares and the then value of the shares. In other words, the option gain is fully taxed.
This tax treatment is less favourable than some of our competitor countries and makes New Zealand a less attractive destination for skilled employees. It also imposes tax before employees have realised the gain by selling the shares and discourages long term shareholding because employees may need to sell the shares acquired to pay the tax. In this regard, the comment of the chairman of Genesis Research in that company's latest annual report is instructive:
"While some staff have sold shares since the IPO, this has generally been to fund the payment of tax liabilities that they have incurred on deemed unrealised profits arising from the conversion of options. In the Directors view this is an iniquitous tax regime which materially hinders the development of emerging industries in New Zealand."
There is a strong case for providing more favourable tax treatment to share options, perhaps along the lines of the Singaporean Entrepreneurial Employee Stock Option Scheme model.
Treating share option gains in a similar way to gains obtained by individual shareholders - which are typically not taxable - would significantly enhance our competitiveness.
There may be a concern that this would result in share options being exploited to turn taxable remuneration into non-taxable remuneration. Simple rules could prevent this from occurring.
Mark Todd is a partner in the Auckland office of Bell Gully. In conjunction with Morel & Co, an investment bank specialising in technology companies, he has established a group interested in the development of employee share ownership in New Zealand. Anyone interested in becoming involved should contact Mark Todd or Matthew McMahon of Morel.
