If you’re building a startup in Australia and want to offer equity to your team, you’ll quickly encounter two acronyms: ESOP and ESS. They’re often used interchangeably — and that’s part of the problem. Understanding what each term actually means, how they differ, and which one fits your situation is critical to getting your equity incentive structure right.
Clearing Up the Terminology
The confusion starts because “ESS” means two different things depending on context.
Employee Share Scheme (ESS) is the umbrella term used in Australian tax legislation — specifically Division 83A of the Income Tax Assessment Act 1997 (Cth) — to cover any arrangement where employees acquire shares, options, or rights in relation to the company they work for. In this sense, every employee equity plan is an ESS. It’s the tax framework, not a specific plan type.
Employee Share Scheme (ESS) is also used colloquially to describe a plan where employees receive shares directly — either at a discount or for free. This is where people contrast it with an ESOP.
Employee Share Option Plan (ESOP) refers specifically to a plan where employees receive options — the right to acquire shares at a predetermined price (the exercise price) at a future date. The employee doesn’t own shares until they choose to exercise those options.
So when people say “ESOP vs ESS,” what they usually mean is: should we give our team options or shares?
Options vs Shares: The Key Differences
The choice between granting options and granting shares has practical implications across several dimensions.
Ownership and Dilution
When you issue shares directly, the employee becomes a shareholder immediately. They have voting rights, dividend entitlements, and they appear on your share register. For a startup with a small cap table, adding multiple employee shareholders early can create governance complexity.
With options, the employee doesn’t become a shareholder until they exercise. This means no dilution of voting rights, no additional shareholders on your register, and no need to manage dividend distributions to a growing pool of employee-shareholders. The dilution only occurs when (and if) options are exercised — typically at a liquidity event.
The 50-Shareholder Limit
This is a practical issue that catches startups off guard. Under the Corporations Act 2001 (Cth), a proprietary company can have a maximum of 50 non-employee shareholders. If you’re issuing shares directly under an ESS, employee shareholders don’t count towards this cap — and under s 113(2)(b)(ii), this exemption extends to anyone who was an employee when they became a shareholder, even after they leave the company. So former employees who received shares during their employment remain exempt. The real risk arises if shares end up in the hands of people who were never employees — for example, through transfers, estate distributions, or secondary sales.
Options sidestep shareholder cap concerns more cleanly. Option holders are not shareholders at all, so they don’t count towards the cap until exercise.
Cost to the Employee
Under a direct share scheme, the employee typically needs to pay something upfront — at minimum 85% of market value to qualify for the startup concession (more on that below). For an early-stage company using the safe harbour net tangible assets valuation, that cost might be negligible. But it’s still a cost, and it can create friction — particularly for junior employees who may not have spare cash to invest in illiquid startup equity.
Options are different. The employee pays nothing upfront. They only pay the exercise price when they choose to exercise, which is usually timed to coincide with a liquidity event (an acquisition, IPO, or secondary sale). This “cashless exercise” structure is one of the main reasons options are the dominant form of employee equity in Australian startups.
Dividends and Voting
Shareholders receive dividends (if declared) and can vote at general meetings. Option holders get neither until they exercise. For most early-stage startups that aren’t paying dividends, this distinction is academic. But for more mature companies, it matters.
The Startup Concession: Where Tax Meets Structure
The startup concession under Division 83A, Subdivision 83A-C of the Income Tax Assessment Act 1997 is the most important tax provision for startup equity plans. It was introduced on 1 July 2015 and fundamentally changed the viability of employee equity in Australia.
Without the concession, any discount an employee receives on shares or options is taxed as ordinary income at their marginal rate — potentially before they’ve seen a cent of actual value. The startup concession eliminates this upfront tax hit.
Eligibility Requirements
To qualify, your company must:
- Be an Australian resident company
- Have been incorporated for less than 10 years
- Have aggregated turnover of less than $50 million in the previous income year
- Not be listed on a stock exchange
- Not be a share trader or investment company
And the participant must:
- Not hold (with associates) more than 10% of the company’s shares
- Be subject to a minimum three-year disposal restriction (or until cessation of employment, whichever is earlier)
How It Works for Shares
If you issue shares directly under the startup concession, the employee must pay at least 85% of market value. The discount (up to 15%) is not taxed upfront. Instead, the shares are placed on capital account and taxed under the CGT rules when eventually sold — with access to the 50% CGT discount if held for more than 12 months.
For early-stage startups, the safe harbour net tangible assets valuation method often produces a very low share value (sometimes fractions of a cent), making the 85% threshold easy to meet.
How It Works for Options
If you issue options, the exercise price must be at least equal to market value at the time of grant. Again, using the safe harbour valuation, this can be a very low number. No tax arises when the options are granted. Tax only arises under the CGT rules when the employee sells the shares acquired on exercise — and the acquisition date for CGT purposes is backdated to when the options were first granted, preserving access to the 50% CGT discount.
The Tax Deferral Alternative
If your company doesn’t meet the startup concession criteria — perhaps it’s been incorporated for more than 10 years, or turnover exceeds $50 million — the tax deferral scheme under Subdivision 83A-B may still be available. This defers the taxing point (rather than eliminating it) until the earlier of: the shares being free of disposal restrictions, cessation of employment, or 15 years after acquisition. The deferred amount is taxed as ordinary income, not under the CGT regime, so it’s less favourable than the startup concession — but still better than upfront taxation.
Which Should You Choose?
For most early-stage Australian startups, an ESOP (options-based plan) under the startup concession is the right choice. Here’s why:
- No upfront cost to employees. Options don’t require employees to put cash in until exercise, which typically aligns with a liquidity event.
- Cap table simplicity. Option holders don’t appear on the share register or count towards the 50-shareholder limit.
- Governance cleanliness. No additional voting shareholders until exercise.
- Tax efficiency. Under the startup concession, options receive capital account treatment with access to the 50% CGT discount.
- Flexibility. You can be selective about who receives options and how many — there’s no requirement to offer them to 75% of employees (that requirement only applies to direct share schemes under the concession).
Direct share schemes make more sense when you want employees to feel genuine ownership from day one, when your company’s valuation is low enough that the cost of purchasing shares is trivial, or when the employees are senior enough to appreciate (and be comfortable with) the risks of holding illiquid shares.
The 75% Rule
One often-overlooked distinction: if you’re issuing shares (not options) under the startup concession, you must offer them to at least 75% of your Australian permanent employees with three or more years of service. This participation requirement doesn’t apply to option-based plans, giving you significantly more flexibility in who receives equity and how much.
For early-stage startups that want to reward key hires selectively rather than offering broad-based equity, this is another strong argument for options.
Getting It Right
Whichever structure you choose, the legal documentation matters. Your ESOP or ESS plan should be consistent with your shareholders agreement, particularly around:
- Vesting schedules and cliff periods
- Good leaver and bad leaver provisions
- Treatment on change of control
- Exercise mechanics and timing
- Board approval requirements for grants
The ATO also provides standard template documents for startup concession schemes, which can be a useful starting point — but they’re templates, not tailored advice.
Conclusion
The ESOP vs ESS question isn’t really about which is “better” — it’s about which structure fits your company’s stage, your team’s needs, and your commercial objectives. For most Australian startups in the early stages, an options-based ESOP under the startup concession offers the best combination of tax efficiency, simplicity, and flexibility. But the details matter, and getting professional advice on both the legal structure and tax implications is well worth the investment.
If you’re setting up an employee equity plan and want to make sure the structure is right for your startup, get in touch. We help startups with this regularly and are always happy to talk it through.
