Employee Share Schemes (ESS) and Employee Share Option Schemes (ESOP) are great for attracting, keeping, and motivating top talent.

But they also introduce one of the most misunderstood issues in private companies:

What is the actual worth of the business for ESS/ESOP purposes? How does this connect with ATO requirements?

If the valuation is wrong, the tax consequences can be significant. If it’s poorly documented, it may not withstand ATO scrutiny. If it doesn’t match commercial reality, it can mess up ownership and future deals.

At RJD Advisory, we approach ESS/ESOP valuation with two priorities:

1. Commercial integrity

2. Technical compliance

Why Valuation Matters in an ESS and ESOP

When a company gives shares or options in an employee share scheme, the employee usually pays tax on the discount between:

• The market value of the shares (or rights), and

• The amount paid by the employee

That market value must be determined in accordance with Australian tax law.

If the valuation is overstated, employees may pay too much tax. If it’s understated, the company and employees face ATO risk.

This is not a “back-of-the-envelope” exercise.

The ATO Framework for ESS Valuation

Under Australian tax law, ESS interests mainly fall under Division 83A of the Income Tax Assessment Act 1997. This includes related ATO guidance and valuation methods. The ATO requires that:

• Shares must be valued at market value

• The valuation must be based on reasonable and supportable methods

• The method must reflect the rights and restrictions attached to the shares or options

For private companies, the ATO provides specific guidance on:

• Safe harbour valuation methods

• Acceptable market-based approaches

• Valuation of options and rights

This means the valuation needs to be fair, well-documented, and supported by strong business valuation methods. It should also be defensible if reviewed.

Safe Harbour Valuation Methods

The ATO offers safe harbour valuation methods for eligible unlisted companies, called start-up concessions. When used properly, these methods reduce audit risk. These typically include:

1. Net Tangible Asset (NTA) Method

Suitable where value is asset-based and earnings are secondary.

2. Earnings-Based Valuation

Often applied using maintainable earnings capitalisation.

3. Discounted Cash Flow (DCF)

Appropriate for growth businesses with forecast reliability.

Early-stage companies can access simplified start-up valuation benefits under specific ESS structures. But safe harbour does not mean “simplified guess”.

The inputs must still be robust, and the business valuation must reflect:

• The specific class of shares issued

• Restrictions on transfer

• Dividend rights

• Vesting conditions

• Liquidation preferences

Enterprise Value vs Equity Value in ESS and ESOP

A common mistake is confusing enterprise value with equity value.

ESS focuses on equity value. This is the value remaining for shareholders after considering debt, shareholder loans, preference shares, and other parts of the capital structure. This is where clean capital structure analysis becomes critical.

For example:

• If a company has $10m enterprise value and $3m net debt, equity value is $7m.

• If there are different share classes, that $7m must be distributed properly among them.

ESS and ESOP participants should pay tax only on what they actually receive, not on a higher headline figure.

Start-ups and ESS Concessions

Australia provides favourable ESS concessions for qualifying start-ups.

Under these rules:

• Options may be taxed on exercise rather than grant.

• Shares may receive concessional treatment.

• There are turnover and age thresholds that must be satisfied.

However, valuation must still reflect market value at grant. The start-up concessions reduce timing risk, they do not remove valuation requirements.

Another consideration is that when the ESS concessions are not available, then a business valuation is required to be performed every year to set the exercise price, and calculate the tax discount on exercise, of options. This means that the grant dates and exercise dates should be aligned as the same day each year otherwise, the business valuation requirement will become too onerous to make the ESS or ESOP viable.

Common Valuation Errors in ESS

We regularly see:

• Using book value instead of market value

• Ignoring shareholder loans

• Failing to adjust for preference rights

• Overlooking vesting restrictions

• Applying public company multiples to private SMEs

• Not updating valuations regularly, especially relevant if the ESS start-up concessions are no longer available

ESS valuations should be refreshed:

• When new funding occurs

• When material performance changes

• When significant capital structure changes occur

• At least annually for active schemes

Interaction with Shareholder Loans

Shareholder loans complicate ESS valuation.

They may:

• Reduce equity value (if payable)

• Increase equity value (if receivable and collectible)

The treatment must reflect commercial substance.

If shareholder loans are misclassified, employees may be taxed on an inflated or distorted equity base.

This is particularly relevant in founder-funded SMEs and early-stage ventures.

Strategic Considerations

An ESS is not just a tax exercise. It affects:

• Ownership dilution

• Control

• Future sale negotiations

• Investor perceptions

• Employee expectations

An inflated valuation makes options feel worthless later. An understated valuation creates compliance risk. The goal is commercial realism with technical compliance.

The Role of Independent Business Valuation

While directors can technically determine market value for ESS start-up concession purposes, an independent business valuation:

• Reduces ATO risk

• Provides objective support

• Protects directors

• Supports investor confidence

• Strengthens future transaction readiness

This is especially important where:

• There are multiple shareholders

• External funding is anticipated

• The business is scaling rapidly

• A future sale is contemplated

• ESS concessions are not available

Final Thoughts

Employee share schemes are powerful.

They align incentives, improve retention, and support growth.

But they must be structured and valued correctly.

Under Division 83A, the ATO expects:

• Market value

• Reasonable methodology

• Proper documentation

• Commercial substance

ESS valuation is not about minimising tax at all costs. It’s about getting the number right, and being able to defend it.

At RJD Advisory, we make sure ESS business valuations are technically sound, commercially viable, and in line with long-term strategy.

Clear structure. Clean modelling. Defensible outcomes.

📞 Book a free consultation today to discuss a business valuation for ESS or ESOP.