Folklore

Structuring, implementing, and communicating your ESOP

As implementing an ESOP requires careful consideration, Folklore suggests engaging legal and financial experts familiar with local regulations. We are comfortable recommending K&L Gates from our experience with them. Our preferred provider directory can also be referred to.

Why implement an ESOP?

ESOPs are a highly effective mechanism for attracting and retaining top talent, and motivating employees by providing them with potential ownership in the company, aligning their financial incentives with business performance. However, to be effective for all parties, ESOPs must be structured carefully to ensure a fair balance of ownership among founders, shareholders, and employees. And ESOP isn’t something you design once and lasts the lifespan of your company. A well planned approach to ESOP design is essential at every stage of the company’s growth and fundraising journey to maintain equity distribution that supports long term success.

Key terms of an ESOP

1. Option pool

This is the portion of equity in the company that is allocated towards share options to be granted to employees (and other stakeholders) in the future
This is expressed as both as an absolute number (of shares) and as a percentage of the total number of fully-diluted (accounting for the conversion of any debt hybrid instruments or SAFEs, as well as any other unvested shares) shares on issue
Typically, the size of the option pool for pre seed and seed companies is around 15%
It is worth considering how the option pool is impacted in the lead up to a fundraising round. It may be the case that the option pool will need to be topped up (more shares allocated to the option pool) such that the % of ownership held in the option pool will not be subject the dilutive effects of the capital raise.

2. Strike price

Set at the time of the grant, representing the price the employee must pay to exercise their vested options in order to convert them into actual shares in the company
Strike prices are often set in relation to the last capital raise share price (and often discounted against this to account for the additional rights afforded to preference shares)
1) If your company has raised less than A$10M in the last 12 months, and 2) your company has annual turnover of less than A$10M or is less than 7 years old, the strike price of options can be set using the Net Tangible Asset (NTA) method (which often sets the strike price on options close to zero for startups with low / zero tangible assets). NTA = (Net Nangible Assets - Preference Shares) / Number of outstanding ordinary shares.

3. Vesting

Vesting period: the amount of time an employee must be employed by the company (typically full time) for their full allocation of options to vest
Vesting cliff: the amount of time that must pass in the employee’s tenure before options are granted. During this period, options accrue, but are only vested once the cliff has been met
Vesting schedule: the rate at which options will vest, and this can be front-ended, linear, or back-ended
Vesting cadence: the frequency at which options vest, typically monthly. Folklore sees a 4 year vesting period with a 1 year cliff to be common practice for Australian startups.

4. Exercisable period

The amount of time that an employee has the right to exercise their option to purchase shares, from the vested options that they have received.

5. Leaver provisions

Good leavers: the employee leaves due to reasonable circumstances (effectively, they are not a Bad Leaver) - all the employee’s unvested options will lapse, and their vested options will typically be held until they are exercised
Bad leavers: the employee leaves due to serious misconduct (commits a criminal offence, severe breaches of their employment agreement or a non compete provision). All the employee’s unvested options will lapse and vested (and unexercised) options may be lapsed, or bought back / transferred to another party, often at a steep discount to their current value.

Setting up an ESOP trust

An ESOP share trust is a legal entity formed to issue, hold, and manage company shares on behalf of employees and to streamline corporate governance
To establish an ESOP trust in Australia, engage legal and financial experts familiar with local regulations
We recommend engaging with Dan Atkin and Simon Leslie at K&L Gates (refer to our preferred provider directory for more)
Ensure compliance with the Corporations Act and with official reporting requirements under the ASIC framework and all applicable tax regulations by consulting with legal advisor as needed
It will be your responsibility to communicate the ESOP details transparently to your employees as well as the official reporting requirements under the ASIC structure
Regularly review and update the trust structure to remain aligned with any legal and regulatory changes.

‍Consideration when determining the right ESOP model for your company

When selecting the appropriate structure, consider three key factors:

Eligibility: what schemes your startup qualifies for
Tax efficiency: The most favorable tax treatment for your company and employees
Incentives and behaviors: How the structure aligns with business objectives and employee motivation (more below).

‍How to effectively communicate ESOP value

It is companies’ responsibility to communicate ESOP to employees. Given their complexity relative to a cash salary, the value of ESOPs to employees are often misunderstood and therefore lack the impact on attracting and retaining strong employees, which is the reason you have one in the first place. It’s important to consider how the introduction of an ESOP will be communicated, being conscious of avoiding financial advice. Here are some considerations:

Communicate in offers and onboarding: explaining and ensuring understanding of ESOP from the initial offer stage is crucial in ensuring employees recognise its value and remain engaged throughout their vesting period. Rather than framing equity as a fixed-dollar amount, it’s important to emphasise that its ultimate worth is tied to future exit scenarios. Misrepresenting equity in monetary terms can create unrealistic expectations and may inadvertently resemble financial advice. Instead include details such as exercise price, vesting schedule, vesting conditions and exit events.
Providing appropriate forums to ensure clarity is important: consider this for both during employee onboarding, and as a refresher for current employees. These forums should cover the basics (what is an ESOP, why do we have one, how does vesting work) as well as provide the tools for employees to consider the value of their ESOP to them (how do I value my options, how do I consider future dilution).
Fixed dollar ownership: statements that apply a fixed dollar or ownership value to ESOP should be avoided, and employees should have clarity on how (and why) the future value of their options is variable.

‍Tax concessions for startups (from 1 July 2015)

When startups give employees equity (such as shares or options), the goal is to structure equity offers legally and efficiently, ideally taking advantage of both simplified disclosure rules and tax benefits for employees. They therefore must navigate two key areas:

Disclosure laws - how the offer is made legally
Tax concessions - how the offer is treated by the ATO.

The Employee Share Scheme (ESS) tax concessions introduced in Australia on 1 July 2015 were a game changer for employees of early stage startups, designed to make equity more attractive and fair from a tax perspective.

What changed? Before July 2015, many employees were taxed on share options when they vested, even if they hadn’t exercised the options yet, the company was illiquid (i.e., no way to sell shares) or they couldn’t afford the tax. This made equity unattractive and risky, especially in startups where cash compensation is often lower.

The 2015 reforms fixed this by deferring when tax is paid and introducing a special startup concession that can make options entirely tax free. To qualify, both the company and the employee must meet each of the following specific conditions:

No company in the corporate group may be listed on any stock exchange
All companies in the corporate group must have been incorporated for less than 10 years
Aggregated annual turnover of the corporate group must not exceed $50 million
The employing company must be an Australian resident company
Employees must hold ESS Interests for at least 3 years
The options must have an exercise price that is greater than or equal to the market value of an ordinary share in the issuing company
An employee may not hold more than 10% ownership or voting rights in the company in which the ESS interests are being granted, including vested and unvested options and aggregating both the current and previous grants
The employee must hold the options or shares as an employee, director, or contractor.

The New ESS Rules

Background: When Australian companies give employees shares or options (called “Securities” under the law), they must follow disclosure laws. These are rules designed to protect investors by making sure they get enough information about what they’re being offered.

Before October 2022: Traditionally, companies could only offer equity if they used a formal legal document like a prospectus, or they qualified for a legal exemption (e.g. small number of people, senior roles only). This made offering equity complicated and expensive, especially for startups and private companies.

What Changed on 1 October 2022? The New Employee Share Scheme (ESS) provisions in Part 7.12 of the Corporations Act 2001 (Cth) were introduced, known as the New ESS Rules. These new rules were designed to make it easier and cheaper for companies to give employees shares or options, without needing a full prospectus.

The goal of the New ESS Rules is to reduce legal complexity, not to reduce transparency. So startups:

Don’t have to issue a full prospectus to each employee
But do have to explain things clearly in short form offer docs
Are still expected to act fairly and reasonably as employers (and often shareholders).

Key features of the New ESS Rules

Key features include:

Issue cap: Offers must not exceed 20% of the company’s shares (or a higher limit in the constitution) over three years
Monetary cap: Employees generally cannot be asked to pay more than $30,000 per year (on average over 3–5 years), unless options are only exercisable on a liquidity event
Disclosure relief: Basic offer documentation is still required, including solvency, financial, and valuation information—typically provided before exercise rather than at the time of offer
Exercise conditions: Options can’t be exercised unless the employee has received required financial information at least 14 days prior.

Please note this is a high level overview of the New ESS Rules. Given the complexity and detailed requirements of the framework, companies should take care to thoughtfully design their employee option plans and offer documentation to ensure full compliance when seeking to rely on these provisions.

Statutory disclosure exemptions

If a startup doesn't meet the New ESS Rule criteria, startups can avoid formal disclosure process by relying on specific legal exemptions in Section 708 of the Corporations Act. These exemptions allow equity to be offered without a full disclosure document, saving time and cost. Why these exemptions matter: They help startups avoid the regulatory burden of producing formal disclosure documents when offering equity to a small group of insiders or early team members, so long as the offers meet specific conditions. The two most common exemptions used by startups are:

1. Small Scale Offerings Exemption – Section 708(1)

This allows a company to make personal offers of shares or options without a disclosure document, provided that, in any rolling 12 month period:

No more than $2 million is raised
No more than 20 people accept the offer
This is sometimes referred to as the "20/12/$2m" rule, and is typically used for early employee equity offers or small scale fundraising.

2. Senior Manager Exemption – Section 708(12)

This permits a company to offer shares or options to senior managers (and certain of their related parties) without disclosure, on the basis that these individuals are already deeply involved in the business and likely to understand the associated risks
"Senior manager" refers to any person involved in the management of the company, regardless of title, this can include executives, founders, or others who take part in decision making.

New disclosure considerations

If a company is not covered under the Employee Share Scheme (ESS) provisions under Part 7.12 of the Corporations Act, nor the available statutory disclosure exemptions under sections 708 or 708AA of the Corporations Act 2001 (Cth), they are required to prepare and lodge a formal disclosure document with the Australian Securities and Investments Commission (ASIC) in accordance with Chapter 6D of the Corporations Act. This document must also be provided to any person receiving the offer of securities.

The most commonly used and lightweight form of disclosure document in this context is an Offer Information Statement (OIS). Startups typically rely on an OIS when offering employee options under an equity incentive plan and no applicable exemption is available. They are important to properly inform and protect employees.

ESOP structure options

Determination of fair market value

Option 1: The fair market value of an Option or Option Share, as determined in good faith by the Board, using a methodology it considers appropriate and applying such methodology consistently across all Options or Shares
Option 2: The fair market value of an Option, as at the relevant date, determined by an independent expert appointed by the Board.

Vesting

Option 1: Standard time-based vesting with 12-month cliff. Subject to the employee’s continuous employment or engagement with a Group Company, the Options will vest as follows: 25% of the Options will vest on the date that is 12 months after the start date; and the remaining 75% will vest in equal monthly instalments over the following 36 months (i.e. 1/36th per month), commencing on the first anniversary of the start date. Vesting will be suspended during any period of unpaid leave. Where such leave includes part of a month, no vesting will occur for that month.
Option 2: Custom time-based vesting. Options vest according to an alternative vesting schedule as determined by the company. This may include, for example, removal of the 12 month cliff or use of a shorter or longer vesting period.
Option 3: Milestone-based vesting. Options vest upon the achievement of specific company or individual performance milestones, as determined and communicated by the Company.

Vesting on exit event

Option 1: No accelerated vesting. Unvested Options will not automatically vest immediately prior to the completion of an Exit Event, unless otherwise determined by the Board in its discretion. Any unvested Options will lapse upon completion of the Exit Event.
Option 2: Partial accelerated vesting (one-year cut-off). Unvested Options that were granted at least 12 months prior to the Exit Event will automatically vest immediately prior to completion. The Board will have discretion to determine whether any Options granted less than 12 months before the Exit Event should also vest. Any remaining unvested Options will lapse on completion.
Option 3: Partial accelerated vesting and continued vesting (uncommon). Unvested Options granted at least 12 months before the Exit Event will automatically vest immediately prior to completion. The Board may determine whether Options granted less than 12 months before the Exit Event also vest. Any remaining unvested Options will continue to vest in accordance with the Plan Rules, unless otherwise required by the buyer or the terms of the transaction. Note: In a share sale, unvested options typically lapse at completion due to buyer requirements. In a business sale, ongoing vesting is less likely to be valuable or retained.
Option 4: Full accelerated vesting. All unvested Options will automatically vest immediately prior to the completion of the Exit Event.
Option 5: Full accelerated vesting. All unvested Options will automatically vest immediately prior to the completion of the Exit Event, unless the Board determines otherwise.

Classifying good and bad leavers

Option 1: Company favourable definition.
- Bad leaver: A participant who ceases employment or engagement with any Group Company in circumstances that do not qualify them as a Good Leaver
- Good leaver: A participant whose employment or engagement with a Group Company ends due to death, permanent disability or incapacity, redundancy or any other reason determined at the Board’s discretion.

Option 2: Balanced approach (includes resignation after 12 months)
- Bad leaver: A participant who ceases employment or engagement with a Group Company in circumstances that do not qualify them as a Good Leaver
- Good leaver: A participant whose employment or engagement ends due to: death, permanent disability or incapacity, redundancy, resignation occurring at least 12 months after the participant first received Options, provided they are not: under formal performance review at the time of resignation, subject to a notice of termination already issued by the Group Company, in breach of their employment or consultancy agreement or any other reason as determined by the Board.

Option 3: Employee favourable approach
- Bad leaver: A participant whose employment or engagement is terminated by the Group Company for cause, including (but not limited to): fraud, commission of an indictable offence, breach of contract or restrictive covenants (such as non-compete or non-solicitation obligations); or, material breach of their employment or consultancy agreement, unless otherwise determined by the Board
- Good leaver: Any participant who ceases employment or engagement in circumstances not qualifying them as a Bad Leaver.

Transfer of options and option shares

Option 1: Unified restrictions on transfers. Except for transfers to permitted affiliates, neither Options nor Option Shares may be transferred, except in connection with an Exit Event, or with the prior written approval of the Board
Option : Split treatment for Options and Option Shares. Except for transfers to permitted affiliates, Options may be transferred, except in connection with an Exit Event, or with the prior written approval of the Board.

Option Shares may only be transferred in accordance with the terms of the Shareholders Agreement (as amended from time to time).

Exercise price for options

Here you must advise appropriate price (must be greater than or equal to the market value of an ordinary share in the issuing company at the date of grant).

Exercise period

This is where you specify the exercise period (i.e. period within which options must be exercised, otherwise they lapse):

Options could range from 5-15 years from the date of grant of the options. Alternitively Options can only be exercised at an Exit Event
‍Note: If the company chooses to rely on the New ESS Rules, only allowing options to be exercised at an exit event may allow the company to avoid issues related to the monetary cap‍
Also note that care needs to be taken if participants are allowed to exercise options prior to an exit event happening. In doing so, they will sit on the cap table of the company and various corporate law issues come into play. Further, care needs to be taken around the interaction of the Company's shareholder agreement and employee shareholders - for example, if the company looks to raise further capital, does it then need to follow a pre-emptive rights process that requires the offer to be made available to employee shareholders.

Other options to consider in your ESOP structure are:

Governing law: Ensure you specify the appropriate state
Leaver arrangements and unvested options for Good Leavers
Leaver arrangements and unvested options for Bad Leavers
Leaver arrangements and shares issued on exercise of options for Good Leavers
Leaver arrangements and shares issued on exercise of options for Bad Leavers.

The next stage

Once you have landed on your ESOP structure, you need to devise your:

Employee Option Plan Rules: The formal governing document that sets out the terms, conditions, and mechanics under which options are granted to employees and other eligible participants. They serve as the legal and procedural foundation for how the company manages its employee equity scheme. An example/template of rules is here.
Employee Option Plan Letter: The individualised document given to an employee (or other eligible participant) that sets out the specific terms of their option grant under the broader Employee Option Plan Rules. It works together with the Option Plan Rules and refers to them, but provides the personalised details of the specific offer. An example/template of a letter is here.
Circular Resolution of Directors: for each director to sign in agreement with establishing the Employee Option Plan in line with the Employee Option Plan Rules. An example/template of a circular resolution of directors is here.

This resource, and any guidance within it, must not be relied on as legal advice. We recommend that you seek professional advice to deliver an outcome best suited to your specific situation.