Navigating Tricky Terrain: Employee Share Schemes

Allowing your workers buy shares within your business can bring a whole host of benefits, but it can be a complex and difficult process

Navigating Tricky Terrain: Employee Share Schemes

Many companies offer some type of share scheme to their employees. Setting up the right scheme in which shares in the company are given to, or bought by, employees can boost morale and productivity significantly. But ensuring the scheme meets the needs of the business is paramount, and all too often what should be a relatively simple process is plagued with complexity particularly in the area of employment law and especially in tax law.

Attempting to resolve these technical and regulatory issues too early in the process can often create additional issues and distort the scheme ultimately adopted. The first rule of share scheme design is to first identify the particular needs and objectives of the business for which it is intended. The design drivers here are simple: who is it for, what should it provide and when should it be provided?

Who is the scheme for?

This is easily identified: the beneficiaries of the scheme are the employees and, in the case of a small business, selected individuals. For most small businesses an “all employee” share scheme will be inappropriate save possibly where some provision for “collective ownership” is made through a discretionary trust holding shares for the benefit of all employees.

The ability to award shares, or an interest in shares, to selected individuals and on a discretionary basis is a fundamental element of the design.

What should it provide?

It is an employee share scheme, so shares, or an interest in shares, would be a good starting point. The key design question here is what form that interest should take: shares (and if so what class of share) or a right to acquire shares (a share option)? The founders will be concerned to incentivise (and keep incentivised) the recipients of the share awards. They will also be rightly concerned to recover these awards where the employee does not perform or possibly chooses to leave their employment with the business.

An immediate award of shares is the provision of a reward not an incentive. It provides only a short term incentive and creates a potentially long term problem for the business if those shares cannot be easily recovered from an underperforming or departing employee. Save for very senior hires (where the role can command an immediate shareholding alongside the founders) the scheme should be based upon options – the right to acquire shares in agreed circumstances and on agreed terms.

Share options have a further advantage over an immediate award: the award under the option can be made infinitely variable. It can be linked to the performance of the individual, department, division, and subsidiary or to the company itself. What is important is not the number of shares over which the individual is granted an option, but the number of shares over which the option may ultimately be exercised, that is vest, and this vesting can be linked to any performance metric that can be measured or any conditionality that can be drafted.

When and in what circumstances?

The economic value of any share derives firstly from the dividends paid on it and secondly from the capital value it can command on a sale or possibly a liquidation. Dividends are not routinely paid on shares in a small business (save where they form part of the overall compensation paid to the founder shareholders which they will not wish to share!). Accordingly, timing the acquisition of shares to enable the participation in dividends is an irrelevance as none are likely to be paid.

The value of a share in a small business lies in the second of its value drivers: the capital return which (in the absence of a listing) will arise on an exit event such as a sale of the company (or sale of its business and subsequent liquidation). In terms of the timing of the provision of the interest (the when) although the share options must exist to provide the necessary incentive the actual ownership of the shares need not arise until an exit event.

It is only at this point that value is crystallised and performance assessed at this point can determine the extent to which the option vests and thereby the extent to which the individual employee participates in the value crystallised.

The final element in the design of the scheme should therefore provide that the option may only be exercised on an exit event and then only to the extent that predetermined performance targets have been met such as to permit the option to vest.

Ultimately when designing a small business share scheme, business owners should look to include the discretionary award of share options granted depending on employee performance, which may only be exercised on an exit event as defined. Setting up employee share schemes need not be a headache if sufficiently planned for and designed well. As Groucho Marx might have said, “A child of five could understand this. Quick, send someone to fetch a child of five!”

Neil Simpson is a tax Partner at haysmacintyre

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