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Employee Share Schemes
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Download Your Free Employee Share Scheme Guide 

_ Guide

Employee Share Schemes
for Privately Owned Companies

Written by

Greg Henry

Published

June 2017

Take this with you

Download Your Free Employee Share Scheme Guide 

A word from the author

Andrew

Hi there,

Thank you for your interest in this guide.

Hopefully it helps to answer some of your initial questions and provides you with useful information for further thought and discussion.

Please note that, as detailed as it is, this guide is only intended to provide a general overview. It is not a substitute for legal advice.

If you would like to know more about employee share schemes or how they might work for you, we would welcome the opportunity to learn about your circumstances and to discuss this in further detail.

 

Greg Henry | Principal
greg.henry@turtons.com
02 9229 2922

Contents

  1. Introduction
  2. An overview
  3. Share Schemes
  4. Option Schemes
  5. Phantom Schemes
  6. Case studies
  7. Designing a scheme
  8. More information

Introduction

Most start-ups and large corporates use employee share or option plans (ESOPs) as the cornerstone of their human resources strategy, particularly in terms of attracting and retaining senior staff. It is curious that more privately owned businesses do not do the same.
The three main reasons why privately owned businesses do not adopt ESOPS are:

  • It never occurred to them.
  • They do not know much about them.
  • They are perceived as expensive and/or time-consuming to implement.

It is undoubtedly true that an ESOP is a significant investment, particularly for smaller businesses. However it is an investment that can bring transformational change. A well-designed ESOP can:

  • help attract and retain high quality staff;
  • provide a source of liquidity for existing shareholders;
  • incentivise staff to behave in ways that align with your corporate strategy.

This guide explains how ESOPs work, when they are used and the three types of scheme that are most commonly adopted.

One of the reasons companies can be slow to adopt an ESOP is that there is no such thing as an ‘off the shelf’ solution.

There are a number of different ways an ESOP can be structured. And although most schemes have some common features, the best scheme for any company will be tailored to align with the commercial objectives of the business and the company’s shareholders.

Types of Scheme

The three most common types of scheme are:

  • 1Share Schemes. Employees buy or receive shares, often with the employer funding some or all of the purchase price.
  • 2Option Schemes. Employees buy or receive options, which can be exercised within a specific period of time and sometimes subject to the occurrence of a particular event.
  • 3Phantom Schemes. Employees do not receive options or shares, but are instead paid bonuses to reflect what the employees would have received, had they been shareholders. These are also often based around the occurrence of a particular event.

Some schemes are broad-based, allowing all of the company’s employees to participate. Sometimes participation is limited to key individuals. Some companies operate more than one scheme at the same time.

What are the Advantages?

As noted earlier, ESOPs can provide a range of benefits to a company’s existing shareholders. They can help:

  • attract staff;
  • retain staff;
  • motivate staff towards a particular goal;
  • provide a source of liquidity for an existing shareholder;
  • change employees’ thinking, so that they start to behave more like owners; and
  • be an important part of a business owner’s succession or exit plan.

It must be emphasised that an ESOP is a medium to long term investment. The benefits of an ESOP will not usually been seen until 3 to 6 years after implementation

What are the Disadvantages?

Some of the main reasons companies do not implement employee share schemes are:

  • Many companies are unaware of how they work and of the benefits they can deliver.
  • Setting them up requires an investment (of both time and cost).
  • They can be complicated and they will have ongoing administration requirements (for example, when new people join or when an existing participant leaves).
  • If they are going to deliver a benefit (which is not guaranteed), that is not likely to happen until over the medium to long term.

For these reasons, the default position for companies is not to have one.

The most traditional type of scheme is one where employees buy shares. Sometimes the issue (or transfer) of shares occurs upfront, and sometimes it is staged over time. Here, three competing considerations arise:

  1. 1Employees are often not willing or not able to pay for their shares upfront.
  2. 2Existing shareholders are (and should be) reluctant to give away the company’s hard-earned equity.
  3. 3Any gifting or discounting of shares can have immediate tax implications for the employee.

An additional consideration is that existing shareholders may not be prepared to give up total control over the company’s affairs.

An effective employee share scheme can balance these considerations in a way that will deliver benefits to the existing shareholders, the employees and the company.

For example:

  • Shares are often sold to employees at a discount.
  • Employers will often loan some or all of the purchase price to participants, with the loan being repaid over time. Dividends and bonuses are commonly required to be applied (at least in part) to repay these loans, and additional payments can be made through salary-sacrifice arrangements or contributions from the employee’s personal resources.
  • Where shares are sold at a discount, and provided the scheme is structured in a compliant way, current tax laws will permit the tax on that discount to be deferred, with the intention that the employee is not required to pay the tax on the discount until the shares are sold.

Additionally, some schemes will involve non-voting shares or trusts to ensure that control of the company remains with the existing shareholder(s).

Where the scheme is being used by a founding shareholder as a vehicle to exit the company, and where participants are allowed to pay the purchase price over time, participants may be required to give security to the exiting shareholder (such as a security interest over the shares being sold, or a reverse option) to ensure the exiting shareholder is ultimately paid in full.

“The key is working out how employees will pay for their shares and also managing the potential tax consequences.”

Most schemes will contain detailed provisions about what will happen if an employee shareholder leaves the company, usually with the intention that the shares will pass back to the company or the existing shareholders. This means that, unless employees commit to remaining for the company for a reasonable period of time (usually at least 3-5 years), they will not stand to gain anything from the scheme.

Where the scheme involves a loan arrangement, some schemes will allow any outstanding balance of the loan to be discharged when the employee leaves the company. This type of arrangement results in there being no cost or risk for participants to join. (Whether that is appropriate really depends on what the scheme is ultimately intended to achieve.)

An option scheme contemplates an employee buying or receiving an option to buy shares in the company at some point in the future.

Usually the options become exercisable on the happening of a particular event, such as the listing or sale of the company, or within a particular period of time.

Option schemes are most suitable for companies that are aiming for:

  • a high rate of capital growth over a defined period of time (usually no more than 5 years); and
  • a specific event to occur that will allow all shareholders to realise their investment.

This is why option schemes are so popular with technology-based start-ups and resources companies. Both involve the investigation and exploitation of specific opportunities that can lead to high growth and exit events if they are successful.

Independently of high growth companies, option plans are sometimes used to ‘top up’ incentives provided to senior managers under a more traditional employee share scheme.

Option schemes will usually contemplate the options being forfeited where the employee leaves the company. They will contain limitations on sale, and they will usually contain limitations on what can be done with the shares after the option is exercised.

Option schemes will have different tax consequences to share schemes. The amount paid for the option (if any), the value of the exercise price and the time in which the option can be exercised are three important considerations.

“Option schemes work particularly well for high-growth businesses and companies where the owners are targeting an exit event in the short to medium term.”

The third common type of employee share scheme does not involve shares at all. Rather, it is a scheme where the participants’ bonus entitlements are calculated to reflect what they would have received, had they been shareholders at a particular point in time. They are often called ‘phantom’ or ‘replicator’ schemes.

A phantom scheme might contemplate a specific proportion of the company’s profits being paid to participants on an ongoing basis (eg annually), or it could envisage participants receiving a fixed percentage of the proceeds in the event the company is sold. There are no limits on how these types of scheme can operate.

The rules of phantom schemes will often allow ‘points’ to be accrued over time. Where there are multiple participants, there are often rules setting out how points are accrued, with different participants accruing points at different rates depending on their seniority and performance over time.

The biggest advantages of phantom schemes is that:

  • they offer ultimate flexibility; and
  • they are usually much easier to implement and administer.

However this leads to their biggest disadvantage, namely that they are the least tax effective of the three different types of scheme.

Whereas share schemes and option shemes can provide CGT relief for participants, concessional tax treatment is not available for participants in phantom schemes.

In the following section are several real world case studies.

For confidentiality reasons, the names of the businesses and individuals below have been omitted. Further details can be provided on request.

A sole shareholder executes a management buyout through an employee share scheme.

Shares

The business was founded and owned by one person. In his 50s, he decided that he wished to slowly pass control and ownership to a new group of managers.

He implemented a scheme that allowed a group of four managers to buy the shares in the business over time. The purchase price was set at the market value of the business at the time the scheme was created. The managers agreed to pay that purchase price over five years, plus interest. The founder took an interest over the sale shares to secure payment of the purchase price.

Within five years of starting the scheme, the owner had exited the venture and the group of managers had come to own 100% of the shares.

A group of founders use a discounted share scheme to incentivise management and convert their interests into a passive income stream.

The company was started and owned by a group of six individuals. They decided that that they wished to incentivise a younger group of managers to play a greater role in running the company, so they could reduce their involvement but remain shareholders.

The scheme committed a select group of senior managers to apply at least half of their annual bonus to buying shares, over a period of 6 years. The shares were sold at a discount. Certain restrictions applied to the shares, so that the managers were able to defer paying income tax on the discount for several years.

To provide the tax benefit to this group of managers, and as a broader incentive for other staff, the founders created a separate scheme that gifted $1,000 in shares to all employees for each year of their employment. Those shares were held in a trust.

Within five years of starting the scheme, the new management team had taken up all key management positions in the company and those founders who wished to reduce their involvement in the business had done so, whilst retaining a valuable source of passive income.

rectangle

A funded start-up uses an option plan to attract new staff.

Shares

The company had raised over $1 million in seed funding, and had set aside a portion of its shares for future managers.

The price at which the funds had been raised meant that it was impractical for the company to use a share scheme to provide equity incentives for new staff members.

Instead, the company implemented a scheme that would deliver options to senior managers over time. Options were issued upfront, however they would vest incrementally over a four year period.

With limited resources available to fund salaries, the scheme gave the company the ability to attract high quality, senior managers with pedigree corporate backgrounds who would not otherwise have considered leaving their previous positions.

An entrepreneur uses a phantom scheme to incentivise performance.

Shares

A sole shareholder decided that she wished to sell her business, but also wished to incentivise her management team to increase the value of the business to maximize her return when the sale was completed.

Several years prior to the sale, she committed to setting aside 25% of the proceeds of sale as a bonus pool for her senior management team. In the three year period leading up to the scheme, managers had the ability to accrue ‘points’ in the team, depending on their performance. When the sale occurred, the pool was divided among the team by reference to the number of points that had been accrued.

One of the challenges in implementing an ESOP is simply knowing where to start. The reality is that this is an area where you will need advice – from an accountant (ideally a tax specialist with specialist expertise in this area), and a commercial lawyer.

In designing the scheme, there are a number of important decisions you will need to make, and a number of questions you will need to answer. Some of them are as follows.

1What do want to achieve from the scheme in the first place?

Is it an exit strategy? Is it to attract new staff, or to reward your existing team? Is it to incentivise staff towards a particular goal, or perhaps long term retention? Designing a scheme will require you to make trade offs. Unless you clearly understand why you want a scheme, it will be virtually impossible to end up with something that is likely to achieve your commercial objectives.

2Are you willing to hand over any degree of control to your employees?

This will have important implications for the design of the scheme. Although studies suggest that the most effective schemes are the ones where participants are given the right to participate in decision-making, many business owners are unwilling to relinquish control.

3Are you prepared to offer something that will be genuinely attractive to employees (either in the short term or over time)?

A scheme will not be effective in influencing employee behaviour unless it is likely to offer a tangible benefit in the foreseeable future. This means two things.

First, the benefit needs to be something of real value. This means that the benefit must be capable of producing a return within the foreseeable future (usually 3 to 5 years).

Second, if you intend to place conditions on the scheme, they must be conditions that are either within the control of the participant or otherwise be realistically capable of being achieved. Again, if participants do not perceive an opportunity to make a genuine gain within the space of a few years, the scheme may not serve as an incentive at all.

4What are the tax consequences of the scheme?

Although this is the last question you should ask (because commercial considerations should drive the structure of any scheme), it is an important one.

Any scheme will have tax implications for both the employer and the employee. To maximize the effectiveness of any scheme, you will need to ensure it is structured as efficiently as possible from a tax perspective. This is an area where specialist tax advice is required.

5What compliance requirements do you need to be aware of?

Some schemes are designed with specific tax concessions in mind. Where concessional treatment is sought, the tax laws may require that your scheme incorporate certain terms. Also, there may be ongoing reporting and administration requirements, depending on the nature of your scheme.

Another important consideration involves the disclosure/prospectus requirements under the Corporations Act. In many cases, employee share schemes will be exempt from the requirements – but again, this depends on the nature of the scheme and the number and type of employees who will be invited to participate.

“Employees who own part of the company think and behave differently to those who don't. That's what makes employee share schemes unique.”

What are the Advantages?

Although this guide is intended to provide you with some detailed information about employee share schemes, there is only so much ground that can be covered in a document like this.

You will find further information about employee share schemes online, including at these websites:

  • Australian Taxation Office information on employee share schemes, available here.
  • ASIC guide to employee share schemes, available here.

Our ESOP workshops are a great way to explore how an employee share or option scheme could work in the context of your organisation.  Read more about our ESOP workshops here.

To learn more, call us today on (02) 9229 2922

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