Attracting and retaining key employees is a challenge for most businesses. There are many factors that impact on an employee’s commitment to a business, with incentive arrangements being a major consideration.
In the past year, we have observed an increasing focus by businesses, in particular medium to large private businesses, on using an employee share plan to incentivise their top performers.
If you are considering an employee share plan, what are some of the main issues you need to consider?
1. Don’t let the legal and tax implications drive the discussion
It may be an unusual statement from a tax advisor, but when it comes to designing an effective employee share plan, the tax and legal implications are very much a secondary consideration. To have an effective plan you need to have a clarity around the commercial objectives being sought from the plan and how they tie into the strategy for the business. Is the aim to improve retention of key people? Is the business strategy to build to an exit in the medium term? The plan should be designed around these commercial objectives. The tax question is then whether the tax outcomes support, or undermine, the commercial objectives (there is nothing like a large unfunded tax liability to dis-incentivise an employee).
2. Good leavers and bad leavers
Consider what will happen if an employee leaves the business. Unless you create rules to the contrary, the ex-employee will retain their shares and all their shareholder rights. This may be fine in some instances (for example, when a long term employee retires) but it can be problematic in other situations (for example, when an employee leaves to join a competitor, or is dismissed for serious misconduct). As a general rule for a private company, ex-employees should not continue as shareholders as experiences tells us that too many issues arise.
3. Dealings with shares
For a public company where shares are traded on a stock exchange, there is an established market for employees to acquire and sell shares. For private companies, it’s the exact opposite. A major challenge for private company share plans is creating a mechanism for employees to be able to sell their shares, without creating a de-facto market that is financially underwritten by the business. It is a difficult balancing act. Added to this financing and administrative challenge is the tax implications. While commercially a share transfer and a share buy-back may seem the same, for tax purposes the two are fundamentally different. One gives rise to capital gains, the other, dividend income. Likewise, dealing in shares at less than market value (say in the case of a bad leaver) can have tax outcomes, such as deemed gains, that are inconsistent with the commercial position.
4. Employees as shareholders
There is an undeniable, but intangible, impact that becoming a shareholder has on employee engagement. It changes their perspective, but it also changes their expectations. They are now an “owner” not “just an employee” and they want to be treated differently such as increased access to information or greater involvement in key decisions for example. One of the most difficult aspects is a sale of the business, where minority employee shareholders can have disproportionate impact on the transaction. The key is recognising and dealing with these potential issues upfront, so everyone is clear where they stand. A shareholders’ agreement is a must.
5. Phantom equity
While numerous businesses have gone on to implement an employee share plan, many have chosen different options. Particularly for established private companies, a more sophisticated bonus based arrangement can be more appropriate. These arrangements are designed to mimic many of the attributes of a share plan, but are fundamentally a bonus arrangement (often these arrangements are termed “phantom equity” or “quasi share” plans). Bonus style arrangements usually have simpler tax outcomes and can be more flexible in their design. However, they are not as tax effective and don’t provide the intangible “becoming a shareholder” benefit.
Whatever path you choose, having a clear focus on the commercial objectives is the first and most important step in ensuring the plan will be an effective incentive arrangement.
Don’t over-estimate the importance of financial rewards. Many studies of shown that if an employee is fairly remunerated, non-financial rewards will provide a greater incentive as compared to additional financial rewards.