The basic idea of any employee share scheme is to give participants the opportunity to acquire equity in the company, or to provide an incentive that is roughly equivalent. There are different ways this can be done, as explained below.
How do employee share schemes work?
The answer depends on the type of employee share scheme you are referring to.
Broadly speaking, there are three types of employee scheme:
- Share schemes - participants buy shares;
- Option schemes - participants acquire options to buy shares later; and
- Phantom schemes - participants receive bonuses (not shares).
We have discussed the potential benefits of employee share schemes elsewhere. The general mechanics of these three types of scheme are summarised below.
1. Traditional share schemes - participants buy shares
The simplest form of scheme is one where employees are given the opportunity to buy shares in the company.
There are two main challenges with this type of scheme:
- participants do not normally have sufficient financial resources to buy their shares (at least not upfront); and
- if a discount is applied to the share price or participants are given shares, this can trigger an immediate tax liability on the part of the participant. (The discount is effectively treated as part of the employee's taxable income.) Read more about the tax treatment of employee share schemes here.
To deal with the first point, non-recourse loans are often made to participants to enable them to pay for the shares over time.
There are ways of structuring employee share schemes to minimise the potential tax consequences for participants. For example, in some cases it may be possible to structure the scheme so that participants can defer paying tax on any discount to the price of their shares for several years or so that the scheme can take advantage of the start-up tax concession.
2. Option schemes - participants acquire a right to buy shares in the future
A second type of scheme is where participants receive options in the company. These options allow participants to acquire shares in the company at a later point in time.
Often the participant will not be required to pay anything for the option upfront. Instead, they are required to pay for their shares when the option is exercised. Usually the exercise price is set at a price that is equal to or slightly above the company's current market value.
Normally, options will not vest (or be capable of exercise) until the conditions in the employee share scheme have been satisfied. These conditions are sometimes based on length of service, sometimes on performance criteria, and sometimes on a combination of conditions.
For example, the scheme may allow a person to acquire options if they remain employed for a period of time. Alternatively, they may need to achieve (and/or the company might need to achieve) defined KPIs for some or all of the options to be issued. You can read more about how vesting periods work here..
The main benefit of employee option schemes is the ease of entry. Employees are normally not required to pay anything to join the scheme. Option schemes give employees the opportunity to share in the value of the company's growth, with no (or minimal) upfront investment.
3. Phantom, replicator and shadow schemes
Sometimes called 'replicator' or 'shadow' schemes, phantom employee share schemes do not involve shares at all. Instead, they entitle participants to receive bonuses that are intended to mirror what they would have received, had they been shareholders.
For example, they might entitle participants to receive bonuses that reflect the dividends they would have received, had they been shareholders. Or they might entitle participants to receive a one-off bonus if the company is sold.
These types of scheme are extremely flexible. Perhaps their biggest downside is that they tend not to be tax-efficient, particularly from the employee's perspective. This is mainly because the employee will not be able to take advantage of the capital gains tax (CGT) concessions that might otherwise be available.
In developing any employee share scheme, there are a number of important decisions that will need to be made. These include:
- the percentage of the company's equity (or equivalent) that should be made available;
- who will be eligible to participate (eg top management only or a broader scheme);
- where shares are being offered, whether they should be ordinary shares and carry voting rights;
- whether there should be a trustee company set up to hold the shares or rights issued to participants under the scheme;
- what conditions employees will need to satisfy before they will be able to acquire shares;
- the length of time the scheme should operate for;
- whether the company should have the right to buy back a participant's shares, and if so when;
- where options are being issued, how long the vesting and exercise periods should be; and
- if loans are made to employees to enable them to buy their shares, how those loans should be treated if the employee leaves the company.
The right type of scheme for your company will be one that has been designed specifically for your circumstances and that is well aligned to your overall strategic objectives. You can read more about other factors to consider when designing a share scheme here.