Updated Valuation Methodologies For Early Stage Companies

Last week, the ATO issued an updated legislative instrument for startups calculating the market value of ordinary shares for employee share and option schemes.

By way of background, in 2015 as part of the Ideas Boom the Turnbull Government introduced a concessional regime for the taxation of employee equity issued by qualifying startups. In summary, group companies that are less than 10 years old and derived less than $50m in group turnover could issue options over ordinary shares which would only be taxed on ultimate sale of the shares (or cancellation of the option), rather than at exercise. In addition, the option would be taxed under the capital gains tax rules, rather than as income. Provided the option was issued at least 12 months prior to the sale, the employee could apply the 50% CGT discount regardless of when the option was exercised.

One of the requirements was that the option have an exercise price at least equal to the market value of the ordinary shares at the time of issue. As part of the changes, the ATO was asked to devise safe harbour calculation methodologies that would avoid requiring early-stage companies to engage external valuers every time they wanted to issue options to employees.

The two methods utilised were:

1. the Net Tangible Assets (NTA) method based on the balance sheet of the company: determine the net tangible assets of the company, deduct any liquidation preference payable to preferred shareholders (i.e., VCs), and then the balance would be divided by the number of ordinary shares and participating preferred shares (if any) on issue. This methodology was available for companies that met all of the following criteria: less than seven years old or that are small business entities, that had raised less than $10m in debt or equity capital in the last 12 months and prepare, or will prepare, a financial report for the year in which the grant occurs, "that complies with the accounting standards under the Corporations Act 2001."
2. If the NTA methodology wasn't available (or if the company preferred), the company could arrange for its CFO or a third party valuer to determine the value of the ordinary share having regard to four specified factors, which would then be endorsed by the board.

The 2015 instrument was due to expire at the end of this month, and so the ATO has issued a new instrument. It is pretty much the same instrument as was issued in 2015, other than:

• The order of the two methods has changed. The NTA methodology is now method 2, and the CFO/valuer methodology is now method 1. This was driven by the ATO's observation that the CFO method is the method most frequently used. That is surprising from our experience where the NTA method has been popular, but no doubt the ATO has greater insight and data on this.
• In the NTA method, the obligation to prepare accounts in accordance with accounting standards has been replaced by a requirement that the company "has prepared, or will prepare, a financial report for the year in which valuation occurs". The obligation to prepare reports in accordance with the accounting standards under the Corporations Act has been dropped. This change is presumably to reflect that not all small proprietary companies are required under the Corporations Act to prepare reports in accordance with accounting standards.

In the lead-up to the issuance of the new instrument, we requested that the NTA methodology take into account the potential dilutive effects of funds that have been raised by SAFEs (Simple Agreements for Future Equity, which are effectively obligations for the company to issue shares at a future point in time, typically during a priced round fundraise). In summary, SAFEs are generally treated as equity for accounting purposes but do not represent shares on issue. Accordingly, while the cash from SAFEs will be included as a tangible asset on the balance sheet, there is no reduction in the value of the ordinary shares to reflect that shares will be issued at a future point in time. We suggested that for this reason, SAFEs should be treated as a liability like convertible notes, and reduce the NTA as a result. However, the ATO considered this would be a policy change beyond its remit and was unable to amend the methodology.

This may lead to incongruous results where the value of an ordinary share in a company that has SAFEs on issue may be higher than immediately after a new fundraise where the SAFEs convert into shares. This may be one factor founders want to take into account when determining whether to issue options to employees pre- or post-fundraise.

The new instrument takes effect from 1 October 2025.