Traditionally the preserve of tech start-ups and large corporates, we are seeing employee share schemes (ESS) increasingly used by all types of small-to-medium sized businesses. A well-designed ESS offers rewards for key employees, an incentive for attracting staff and potential for succession planning. This article discusses some common features of ESSs and a few pitfalls to avoid.
Scheme structure
Just as every business is different, every ESS is unique. It is common for start ups (especially in the tech sector) to issue employees with options to acquire shares at a nominal exercise price. If all goes well, the price at which the employee exercises options is below the market value of the shares. The advantage of options is that normally no tax liability arises for the employee until the options are exercised (see below). Options can also form part of an employee’s remuneration or a reward for performance. Another possibility is that exercising options may be tied to a so-called “liquidity event”, such as the sale of the company. The upshot is that the employees receive the net proceeds of the sale of shares at the same time as exercise of the options and do not need to fund the exercise price themselves.
In contrast, a mature and established business may prefer a staged arrangement that increases employee ownership over time. The entitlements may be subject to performance-related conditions or to long service.
Funding
One possibility might be to simply gift shares in your company to an employee. However, this has tax implications for the employee (see below) and leaves a number of unresolved questions if the employee leaves or there is a sale of the business. A simple alternative is to allow an employee to purchase shares at their market value (the employee then benefits from the increase in value of those shares through growth of the business). Another variation on this approach is that companies will often provide an interest free loan to assist the employee with paying for shares. This loan may be paid off over time through dividend payments, cash bonuses or as part of remuneration.
Departing employees
If an employee who has participated in an ESS leaves your company, he or she will remain a shareholder unless you have made an agreed basis about what happens to their shares. A well-drafted ESS plan will include “good leaver” and “bad leaver” terms to deal with this scenario. For example, a “bad” leaver may forfeit any unearned entitlements and be compelled to sell back shares (possibly at a discount). Conversely, if the scheme relies on participants gaining entitlements over time, those conditions may be deemed fulfilled if the employee is a “good” leaver.
Business sale
Perhaps the most important benefit of an ESS from an employee’s point of view is the prospect of sharing in the proceeds of a business sale. This scenario should be contemplated when drafting the ESS terms. For example, employees usually hold a minor percentage of shares. Customary “drag/tag” rights will enable the employees to be brought along with the majority shareholder when the company is sold. As already discussed, the ESS terms may only allow for cash gains for employees to crystallise on the business sale.
Disclosure requirements
The terms of an ESS can be largely set by the company as it sees fit. However, there are mandated warning statements that must be provided to ESS participants and you must give participants access to annual reports. A good ESS will include template documents for participants that meet these disclosure requirements.
Tax
Last but certainly not least, the tax implications of an ESS need to be considered. Broadly speaking, if an employee is issued shares for less than market value, the difference between the issue price and the market value is treated as part of the employee’s taxable income. Tax deductions may also be available to the employer in relation to benefits to employees under an ESS. There are also filing requirements. When planning an ESS, you should also discuss the tax issues with your accounting or tax adviser.
If you are thinking of putting an ESS in place, or have questions about your existing arrangements, please do not hesitate to contact us. We have specialists with experience advising on schemes for the full range of business types.
Click here for other Corporate Law articles.
