Creating a successful employee share scheme is all about careful planning. Because there are so many ways you can structure a structure an employee share scheme, it is important to keep a few basic principles in mind.
1. Make it attractive to participants.
As obvious as this may sound, this is a point that can easily be lost in the process of designing a scheme.
There are several ways you can make an ESOP attractive to employees.
First, participants need to be able to understand what they stand to gain from the scheme, in real world terms. The presentation of financial modelling against different scenarios (with appropriate disclaimers) can assist with this.
Second, there must be a realistic possibility of participants receiving a financial return from the scheme at some point within the foreseeable future, in an amount that would be material to them. Sometimes this return can be by way of dividend flow, but more often the incentive is the prospect of receiving a large capital payment when the company is sold or listed.
Third, there should be low (or no) barriers to participation. This typically means ensuring:
- participants can afford to join the scheme (noting that many schemes do not require any cash payment or other investment by employees in exchange for their shares or options); and
- if there is to be a reduction of participants' take-home over the life of the scheme (for example, cash bonuses), there will be an obvious benefit to employees in exchange for this sacrifice.
Fourth, the structure of the scheme should be as simple as possible, so that participants can understand how it works. Keep in mind that there are a number of different ways to structure an ESOP. For example, how option schemes work is very different to how employee share schemes work. The rules of the scheme should be written in a way that can be easily understood by those you are hoping to incentivise.
Fifth, any targets (or penalties) should be written in objective terms, so that participants can have confidence that the scheme will be administered by the company as intended. For example, where entitlements are subject to the achievement of performance metrics, those metrics should be described in objective terms. Although there will be instances where it is appropriate for the company to retain a discretion in relation to the administration of the scheme, ideally those instances should be kept to a minimum. Otherwise this can have the effect of diluting the incentive.
Finally, from a tax perspective, the scheme should be structured so that it offers the greatest possible net return to participants. Tax considerations are discussed further below.
2. Commercially aligned
Before getting into the detailed design of an employee share scheme, it's important that you have a clear picture of what you are trying to achieve from it.
For example, your main objective might be to:
- attract new, high quality people to your organisation,
- incentivise an existing management team to grow the business,
- reward key employees for their ongoing loyalty to the business, or
- use the ESOP as part of a broader succession plan.
Whatever your reasons for having an employee share scheme, maintaining a clear picture of your commercial objective will be of enormous value in designing the scheme. It will help you answer questions like:
- Who should be eligible to join the scheme?
- What ESOP vesting rules should apply (if any)?
- Should participants' entitlements be subject to future performance? And if so, what benchmarks should be used?
- Should participants have voting rights?
- What should happen to an employee's entitlements if they leave the company?
Although it will obviously be important for you to understand the different ways you can structure an employee scheme, the key thing is for you to keep your commercial objectives front of mind, so that you can test the scheme design against those objectives as you are developing it. Assuming you engage the right advisors, they will be able to recommend the most appropriate structure.
3. Tax Efficient
The tax rules that apply to employee share schemes are complicated. The way you structure your scheme can make a big difference to the amount of tax participants will be required to pay - both when they join the scheme, and when they eventually sell their interests.
Two important concepts to understand are:
- If participants are not required to pay full market value for the shares or options they receive, they can be required to pay tax on that 'discount' when they join the scheme.
- If participants are able to access CGT discounts when they eventually sell their shares or options, this can make a significant difference to the amount of tax they will be required to pay and, in turn, the total net benefit they stand to receive.
There are different ways you can structure an employee share scheme, to make sure it as tax efficient as possible. Read more about employee share scheme tax here.
4. Specialist advice
Because there are so many factors that go into the design of an employee share scheme, it is important to make sure you get the right advice. Consultants with specialist expertise will have plenty of experience in designing schemes, and will therefore have suggestions and insights that you won't have thought of. The cost of their advice is likely to be small in the context of the overall objectives of the scheme, and the return that it stands to generate if it is successful.
Typically, three types of specialist are involved.
First, if they do not have the expertise in-house, companies will often engage a remuneration consultant to help them design the overall remuneration package for potential participants. This exercise can sometimes involve a restructuring of existing packages, particularly around bonus structures. It can also involve a benchmarking process, so that you can understand whether you have the right balance between the different elements of the package (eg base pay versus short term incentives versus long term incentives), having regard to what other companies might be offering and broader market practice.
Second, you will need a specialist tax advisor who has specific expertise in employee share schemes. The tax laws relating to employee share schemes are complicated, and change on a regular basis. Advisors who specialise in employee share schemes will be able to give you better advice, most likely at a lower cost, than a generalist advisor or accountant (who would need to spend time coming up to speed with the tax rules, and who may not have much insight into the different structures commonly adopted by companies in response to those rules.)
And finally, you will need a specialist commercial lawyer, like us, to help guide the process, prepare the scheme rules and advise on any compliance issues that might arise (for example, in relation to any Corporations Act requirements or any requirements that may arise under the company's shareholders agreement).
Engaging a lawyer who regularly advises on employee share schemes will give you access to case studies, examples and expertise gained from past experience. For the best results, we would always suggest engaging your tax advisor and lawyer at the same time, so that they can work with you as a team.
We are regularly help companies design and implement employee share schemes. Consequently, quite apart from benefiting from our own experience and expertise, we are able to recommend accountants and other consultants who specialise in this area.
If you are considering implementing an employee share scheme, a 1 hour ESOP workshop could be a great place to start.