A growing private company decides to give a key employee a stake in the business. Everyone agrees on the principle, the offer is drafted, and the employee is keen. Then the accountant asks what a share is worth on the day it's issued, and the conversation slows down.

Employee share schemes and option schemes have been common in listed companies for years. They're now spreading through Australian private companies, where they can be a real way to attract and keep the people a business depends on. Structured well, they give employees a genuine stake in how the business performs.

The part that gets missed is the business valuation. In a listed company the share value is the market price. In a private or unlisted company, there’s no quoted price, so the value has to be worked out. This number carries tax and reporting consequences that can last a long time.

Why does an employee share scheme need a business valuation?

Because in a private company there's no market price, and the value of the shares or options sets the tax. Under Division 83A of the Income Tax Assessment Act 1997, employees usually pay tax on the difference between the market value of shares or options and their purchase price. The valuation sets that discount, which means it sets the taxable benefit.

Price it too high and employees can pay tax they didn't need to. Price it too low and the arrangement may not hold up if the ATO looks at it. Either way, the documentation behind the figure has to be clear enough to defend.

How are private companies valued for an employee share scheme?

The ATO expects a reasonable and supportable method for arriving at market value. The common approaches are:

• capitalisation of maintainable earnings, often suited to stable SMEs

• discounted cash flow, where value is driven by forecast cash flows

• market multiples, benchmarked against comparable transactions

• net tangible asset value, more relevant for asset-heavy businesses

Which one fits depends on the business and its financial profile. A method that suits a mature trading company can be the wrong choice for an early-stage or asset-heavy one.

What's the difference between equity value and enterprise value here?

Enterprise value is what the whole business is worth. Equity value is what the shares are worth once you account for the capital structure. The mistake I see most often is treating one as if it were the other. Employee share scheme participants receive equity, so equity value is the figure that matters.

To get from enterprise value to equity value, adjust for:

• Debt

• Shareholder loans

• Surplus cash

• Preference shares

• Similar items

Skip those adjustments and the value of the shares issued under the scheme can be well off the mark.

How are options valued for an employee share scheme?

With an option pricing model rather than a straight share value. Many schemes issue options instead of shares, and the ATO generally accepts the Black-Scholes and binomial models.

The inputs do the heavy lifting. Volatility, exercise price, expected life, and interest rates all affect the outcome. Even small changes in these assumptions can lead to very different values. That's a reason to document how each input was chosen, not just the final number.

Do start-up concessions remove the need for a business valuation?

No. Australia offers employee share scheme concessions for eligible start-ups. This includes lower tax rates and, for some schemes, tax deferral until after the grant. These help, but they don't remove the need for a proper valuation when the interests are issued.

The concessions provide safe harbour valuation methods for eligible companies. This helps with internal valuations. That isn't licence for a rough guess. A company not covered by the concessions needs a valuation at each grant and exercise date. That’s why these dates are usually set for the same time each year to manage costs.

Where do employee share schemes go wrong?

The recurring problems are consistent:

• using book value instead of market value

• ignoring shareholder loans

• not adjusting for different share classes

• letting valuations go stale

• applying listed company multiples to a private SME

An employee share scheme business valuation should be reviewed in these situations:

• When capital is raised

• When the business changes significantly

• When new equity is issued

• At least once a year while the scheme is active

Why use an independent business valuer for an employee share scheme?

Because it lowers the risk if the ATO reviews the scheme, and it carries more weight with everyone relying on the figure. Where safe harbour applies, directors can sometimes set market value themselves. A business valuation keeps directors safe, reassures investors, and shows employees they are valued. It also leaves documentation that stands up if the scheme is ever examined.

What owners should take from this

An employee share scheme is a great tool for a growing business to retain talent. It’s most effective when the business valuation is realistic and defensible. The figure should reflect the fair value of the equity, not just the lowest convenient number.

Once equity is issued, that number follows the business for a long time. If you're setting up a scheme, or already running one, it's worth making sure the valuation would hold up.

Talk to RJD Advisory

RJD Advisory offers independent business valuations for small and medium businesses throughout Australia. This includes valuations for employee share schemes and option schemes. If you're setting up a scheme or want to check that an existing one would hold up, get in touch for a conversation.