Valuing ESS Interests

A company, whether listed or unlisted, can grant its employees an interest in its equity (ESS Interest), including through an employee share scheme (ESS) or employee share option plan (ESOP).  There are restrictions contained in both the Corporations Act 2001 (Cth) (Corporations Act) and Income Tax Assessment Act 1997 (Cth) (ITAA) that determine the price at which ESS Interests can be offered to ESS Participants.  The Corporations Act and ITAA both require that offers of ESS Interests be supported by a valuation.^[1]  This article will discuss why a valuation is required for an ESS and ESOP, and the methods that may be used in reaching them.

Understanding ESS Interests

An ESS Interest in a body corporate (Company) will typically be either a fully paid ordinary share(Share) or a right granted in relation to, or option to acquire, an interest in a fully paid share (Option).^[1]  An ESS Interest may be offered for monetary consideration or no consideration^[2], which will, in turn, affect the contents of an ESS offer document, referred to as ‘disclosure‘.^[3] 

Valuation requirement

A valuation of a Company’s shares is required for the purpose of disclosure when delivering an ESS or ESOP offer document to eligible employees.  This is particularly necessary for unlisted Companies, given they are generally more illiquid and unpredictable.  Section 1100X of the Corporations Act contains the additional disclosure requirements that apply to offers of ESS Interests by unlisted bodies as follows:

“Supporting information for offers by unlisted bodies corporate

(1)  The supporting information required by this section is:

(b)  a document covered by subsection (3) (about valuations) in relation to the ESS interests being offered; and

Valuation Information

(3)  This subsection covers the following documents in regard to the valuation:

(a)  a copy of a valuation of the ESS interest that has been prepared consistently with an applicable method approved by the Commissioner of Taxation under section 960-412 of the Income Tax Assessment Act 1997 (Cth).

 Default valuation method for unlisted shares.

A valuation must include the calculation of the market value of an ESS interest.^[4]  Section 83A-315 of the ITAA states that to determine the market value of an ESS interest, the Income Tax Assessment (1997 Act) Regulations 2021 (Cth) (Regulations) should be consulted.  Regulation 83A-315.01 states that:

• “For the purposes of subsection 83A-315(1) of the Act, the amount specified, in relation to an ESS interest that is an unlisted right that must be exercised within 15 years after the day when the beneficial interest in the right was acquired is, at the choice of the individual:

(a)  the market value of the right; or

(b)  the value worked out in accordance with sections 83A-315.02 to 83A-315.09.”

Regulations 83A-315.02 to 83A-315.09 are structured as follows:

• 83A-315.02 – valuing unlisted shares
• 83A-315.03 – exercise of price right nil or cannot be determined
• 83A-315.04 – value of beneficial interests
• 83A-315.05 – working out the value of a right to acquire the beneficial interest in a share
• 83A-315.08 – calculation percentages of fifty percent (50%) or more, and less than one hundred and ten percent (110%)
• 83A-315.09 – base percentages for calculation percentages of one hundred and ten percent (110%) or more

Section 83A-315.02 states that the value of an unlisted right will be the greater of:

• “the market value, on the particular day, of the share that may be acquired by exercising the right, less the lowest amount that must be paid to exercise the right to acquire the beneficial interest in the share; and
• subject to sections 83A-315.03 and 83A-315.04, the value, on the particular day, of the right to acquire the beneficial interest in the share worked out in accordance with sections 83A-315.05 to 83A-315.09.”

This default valuation method is to be applied by most companies offering unlisted ESS interests to employees.  An alternative method may only be applied in specific circumstances, including where a company satisfies the conditions required for a start-up concession.

Valuation methods under the start-up concession

Legislative instrument 2025/19 (LI 2025/19), Income Tax Assessment (Methods for Valuing Unlisted Shares for the Employee Share Scheme start-up concession) Legislative Instrument 2025, was issued by the Australian Tax Office (ATO) under subsection 960-412(2) of the ITAA.  It prescribes the methodology to be used in the valuation of unlisted shares for start-ups in relation to ESS offers.  These methods include the comprehensive method and net tangible asset method.

The Explanatory Statement to LI 2025/19 provides further guidance on LI 2025/19 and when each method is to be applied.  Both LI 2025/19 and its explanatory statement indicate that:

• The application of methods is conditional, and section 6(1) must be satisfied to complete a valuation.  Where this condition is not met, no ESS interest can be offered and therefore a valuation is not required.
• If sections 6.1(a) and (b) of LI 2025/19 are satisfied, the comprehensive method will apply.
• If sections 6.1(a) and (b), and 8.2, are met, a company may choose between the comprehensive method and net tangible asset method.  It is more likely that the net tangible asset method is preferable as it may be of lower cost or likely to yield a better value.
• If sections 6.1(a) and (b) are met, and a company would prefer to use an alternative method, they may do so as per section 6.2 of LI 2025/19 where that method is fair and results in a value not less than market value.

A Company may decide which method is applied based on the individual circumstances and requirements of that Company.  A Company may choose a method that results in a more favourable market value so long as that method complies with the ITAA and LI 2025/19.  In all cases, the Company must satisfy section 6(1) of LI 2025/19 which states that:

“(1)  The methods set out in sections 7 and 8 are approved for working out the market value of an unlisted ordinary share in a company, for the purposes of determining if the conditions relating to market value in subsection 83A-33(5) of the Act are satisfied, if:

(a)  the company provides an ESS interest to a participant at that time; and

(b)  the company’s directors reasonably anticipate that there will not be a change of control of the company within the period ending 6 months after that time.”

How to apply each method under the start-up concession

Method one (1) – comprehensive method

A Company may choose to apply this method where it provides a higher market value than method two (2), or where the company does not satisfy the additional conditions required to apply method two (2).  The limitation of this method is that it could potentially yield a higher value than method two (2).  This method is appropriate where:

• less than ten (10) million dollars of capital was raised in the twelve (12) months prior to the valuation date; or
• more than ten (10) million dollars of capital was raised in the twelve (12) months prior to the valuation date, the company is more than seven (7) years old at the valuation date, and more than ten (10) million dollars of turnover is expected in the valuation year or prior year.

Under this method, the valuation of shares must be done by:

• the chief financial officer of the Company; or
• a person having the skill, knowledge, and expertise to determine the market value of unlisted shares in a Company.^[5]

To apply this method, there must be a valuation in writing which considers:

• the value of tangible and intangible assets of the company;
• the market value of similar businesses (including the use of earnings multiples);
• uplifts and discounts for control premiums, lack of marketability, and key person risk; and
• the present value of anticipated future cash flows.^[6]

This valuation must be endorsed in a written resolution by the directors of the company.^[7]

Method two (2) – net tangible asset method

A Company may choose to apply this method where they would prefer a simplified approach to valuation.  This method only considers tangible assets and does not consider any intangible assets or projected cash flows, which may lead to the calculation of a higher market value.  However, further conditions must be satisfied for a Company to be eligible to apply this method.  This method is appropriate where:

• the entity is less than seven (7) years old at the valuation date and raised less than ten (10) million dollars in capital twelve (12) months before the valuation date; or
• the entity is more than seven (7) years old at the valuation date and has less than ten (10) million dollars of turnover expected in the valuation year or prior year.

To apply this method, the following conditions must be satisfied:

• the Company has not raised over $10 million in capital (either debt or equity combined) over the period of 12 months immediately before the time of valuation; and
• at the time of valuation, the Company either:

(i)  is a small business entity as defined in section 328-110 of the ITAA; or

(ii)  has been incorporated for not more than seven (7) years; and

• the Company has prepared, or will prepare, a financial report as defined in section nine (9) of the Corporations Act for the year in which the time of valuation occurs.^[8]

The steps in applying this method are as follows:

• Work out the NTA value of the Company, which refers to the total assets excluding any intangible assets less liabilities as recognised in the financial report.
• Work out the amount required to discharge the company’s obligation in respect of its preference shares on issue at the time of valuation if those shares were redeemed, cancelled, bought back, or otherwise satisfied at that time.
• Subtract the step two (2) amount from the step one (1) amount.
• Work out the value of the ordinary shares on issue by reference to the claim ordinary shares have on the amount remaining.^[9]

Alternative method

A Company may choose to apply an alternative valuation method where this results in a higher market value of its shares.  This option may be beneficial where a company wants to tailor their valuation method to their specific circumstances.  Examples of alternative valuation methods include a discounted cash flow model and valuations prepared for capital raising purposes.

However, this valuation method must satisfy section 6(1) of LI 2025/19 and the market value produced must not be less than the value it would have resulted from using an approved method that a Company was eligible to use.

Conclusion

To summarise, for companies offering ESS interests to employees, a valuation will be required under section 1100X of the Corporations Act.  Ordinarily, the default method under section 83A-315.02 of the Regulations will apply, which provides a basic method of calculating the market value of a share or option to acquire a share.  Alternatively, where conditions are met for a start-up concession, then a company may apply a comprehensive method, net tangible asset method, or alternative method of valuation.  It is important that companies reflect on which valuation method may be the most appropriate and beneficial, ensuring compliance with the required conditions.

Links and further references

Legislation

Corporations Act 2001 (Cth)

Income Tax Assessment Act 1997 (Cth)

Income Tax Assessment (1997 Act) Regulations 2021 (Cth)

Further information

If you need advice on employee share schemes and issues arising from valuing unlisted shares, contact us for a confidential and obligation‑free discussion

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances

[1] Corporations Act 2001 (Cth) s 1100M.

[2] Corporations Act 2001 (Cth) s 1100P.

[3] Corporations Act 2001 (Cth) s 1100W.

[4] Income Tax Assessment Act 1997 (Cth) s 960-412.

[5] Explanatory Statement to LI 2025/19 para 16.

[6] Explanatory Statement to LI 2025/19 para 17.

[7] Explanatory Statement to LI 2025/19 para 18.

[8] Explanatory Statement to LI 2025/19 para 19.

[9] Explanatory Statement to LI 2025/19 para 21.

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[1] Corporations Act 2001 (Cth) s 1100X.