Employee Share Schemes And Equity Arrangements

Employee Share Schemes (ESS) can be a powerful tool to lock in and incentivise your high performing and strategically important staff. Implemented effectively, an ESS can help to achieve alignment between the employee’s behaviours and the business’s goals. To put it simply, when it works the employee starts to treat the business like it is their own, and this leads to improved productivity, a focus on cost management and increased morale.

ESS arrangements can take many forms and can be tailored to achieve the desired outcome or cater to your specific circumstances.

Common Share Plans And Equity Arrangements

1. Performance rights – is an option for the employee to purchase shares in the company in the future once they meet a performance condition. The option will usually be offered at a discount to market value to make it attractive, and the vesting condition could be a specific target, or simply a tenure condition. eg work for 3 years.
2. Bank funded shares or options – is the most common method where the business is mature, and the current shareholders wish to sell down their shareholding. Typically, the business will guarantee the loan or otherwise allow the shares to be used as security. In addition, the loan terms will be tailored so that the repayments can be funded out of the employees share of business profits. We are aiming for a cashflow positive position for the employee after paying off their loan.
3. Vendor funded shares or options – this is often an effective solution where the business wants to expand and lock in staff, and also wants to realise market value for their equity. Practically, the business will fund the employee to purchase the equity via a loan, and the employee will allow a portion of their ongoing dividend to be used as a loan repayment. The employee eventually pays off their loan without having to fund the shares personally.
4. Whilst not strictly an ESS, a phantom equity arrangement is a great solution if you are not quite ready to give up real equity. It’s basically a taxable bonus which is linked to the business profits (akin to a notional dividend). For added lock in the bonus can be staged – for example 60% paid in year one and 40% in year two.

The Key Question To Ask

Is the ESS arrangement part of an exit plan or succession arrangement in a mature business or are we focussed on locking in our key stakeholders in a growing business? The answer to this question will determine if the plan will involve offering shares at market value and helping the incoming shareholders to fund the purchase price, or alternatively, whether we are focussed on lock in via a discounted plan.

The Challenges

• Where we offer shares or options to employees at a discount to market value, the discount can be assessable income to the employee, often at a point in time when they don’t hold the shares.
• For listed companies with a liquid market, valuation and disposal of shares is relatively easy, but for SME’s valuations become expensive (particularly for small equity tranches) and we don’t want our employees to have to sell their shares to fund their tax bill.

The Solutions

Where shares are offered at a discount, we will seek to utilise the ESS Start Up Concession. The main hurdle to qualify for the concession is that the entity has been incorporated for less than 10 years. This concession will work to defer any taxing point until the employee disposes of the shares.

Where the entity has been incorporated for less than 7 years or is a small business entity, we can utilise the net tangible asset (NTA) method to value the shares. Basically, we can use the net assets in the balance sheet as a means for valuation of the option, rather than having to shell out big dollars for a valuation. This is fantastic for SME clients.

Next Steps

Its important to seek out specialist advice to ensure that your ESS solution is the right fit for both the employee and the business and doesn’t cause any unintended tax headaches. With proper advice you can find a solution that will work for all parties and find the alignment and buy in that you are looking for.

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Disclaimer: This information is general in nature and should not be relied on as advice. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs and seek professional advice before making any decisions based on this information.