Heard of ESOPS – employee share ownership plans? Very possibly. Loan bonus schemes, performance share rights, phantom shares? Less likely.
All are ways of providing (usually senior) employees with a stake in the business. But what options are on offer, and what would work best for your organisation?
We outline some of the obstacles in implementing a plan and some of the factors involved in plan design.
Why have an ESOP?
ESOPs can provide a range of benefits:
a retention incentive for key employees
an exit strategy for current owners
a mechanism to expand the ownership structure of the firm
a longer term capital appreciation opportunity for employees than the cash bonus, or
a way for growth companies to promote staff loyalty while conserving cash for operational reinvestment.
Longer duration vesting terms linked to continued employment can ‘hand-cuff’ an employee to stay with a business in a way that shorter term incentives cannot.
What do you want to achieve?
Numerous plan structures and features exist. The key is to distil clearly your organisational objectives and design the plan in a way which maximises the prospects of achieving them. It must be an efficient and effective solution.
There are competing objectives and compliance requirements to evaluate and balance. The analysis might include financial simplicity and general "perception" considerations, together with tax, securities, company, contract and employment law issues.
Some plan options
“Basic” share plans
The basic model involves the acquisition by employees of new or existing shares in an employer group company.
the period during which shares are subject to the plan
whether the shares are held by the employee directly or through a custodian
whether the employer lends the employee the money to acquire the shares
payment requirements, and whether the employer pays a cash bonus to the employee that allows the employee to repay a loan.
A downside of loan/bonus share schemes is their complexity.
Taxation exemptions apply to “Exempt ESS” plans. The plan must be open to at least 90% of employees on an equal basis and must comply with various criteria.
The principal advantages of an Exempt ESS are that it:
creates a sense of widespread co-ownership at relatively low cost, and
is tax-efficient – shares may be issued at up to a $2,000 discount to market value per annum to each participating employee.
Some schemes are structured as a $2,000 (or less) bonus, settled in shares. Others provide for the employer to lend the employee money to be repaid over a maximum five-year term, for example through payroll deductions and dividend payments.
The main disadvantage of the Exempt ESS model is that the maximum value of shares provided under an Exempt ESS is $5,000 per annum, inhibiting the ability to confer a substantial benefit on executives.
Until recent tax law changes, Exempt ESS shares had to be held on trust. Where trust structures are already in place, employers may elect to retain them for purposes of administrative efficiency until employee loans are fully repaid. Some employers outsource administration of their Exempt ESS to their share registrar.
Options and Performance Share Rights
These are popular instruments for employee equity participation and are generally straightforward and well understood by most employers and employees.
Employees receive options to acquire shares at a predetermined price after a period. Contingencies usually attach to options. If they occur, the options can lapse.
A variation to the standard option is the performance share right (PSR). In effect, employees obtain shares on the exercise of PSR for no cash payment.
Tax inefficiency was a significant problem with standard option plans but this has been removed through a recent law change allowing employers a tax deduction equivalent to an employee’s taxable gain.
“Phantom” share plans
While less common, some companies have put in place "phantom" share plans (essentially a cash bonus scheme where the amount payable is determined by tracking share value/price performance).
Plan benefits add to base remuneration
Often a plan adds an "at risk" increment to an employee's fixed base pay package to provide a long‑term incentive (as opposed to short‑term remuneration or bonuses).
The goal is to create the right incentives by aligning an employee's interests with those of the company. Both parties stand to benefit directly from an increase in the share value/price.
Some plans are retention measures only but most combine remuneration/incentive and retention components. On limited occasions, a plan is put in place to raise capital for the company.
Other plans may be intended to do no more than engender a sense of co-ownership and common interest between employer/employee. Sometimes a plan is developed to introduce new business owners. It can also be a useful exit strategy for existing owners.
These purpose factors should shape the design of the plan. For example, employers should consider the weighting of benefits (front-end load or deferred), restrictive/vesting periods and the extent of participation (all employees and directors or selected employees only).
Who bears the risks?
A number of questions need to be considered in determining the plan risk profile.
Should the employee have to contribute cash to the plan? If so, when?
Should there be a “salary sacrifice" component, or are benefits supplementary to existing remuneration?
Will there be performance hurdles? Will they be pitched at the individual or at the company level? What measures will be used? Profitability? Economic value-add? Whatever they are, care needs to be taken not to create perverse incentives.
Will the company lend funds to employees for payments under the plan? If so, will the loan be with or without limited recourse for non-payment?
Will some sort of savings scheme arrangement be implemented, for example, periodic payroll deductions to pay for securities or repay loans?
Securities law compliance
The Securities Act 1978 made it difficult for employers to offer share or option schemes to all but the most senior executives without a prospectus and investment statement, with severe penalties for non-compliance. But these complexities have been largely swept away by the Financial Markets Conduct Act 2013 (the FMCA).
Clause 8 of Schedule 1 of the FMCA, together with the Financial Markets Conduct (Employee Share Purchase Schemes) Exemption Notice 2016, provides a comprehensive exemption from the “regulated disclosure” requirements if:
The warning notice now needs to be included with Exempt ESS offers.
For listed issuers, the insider trading prohibitions in Part 5 of the FMCA can impose some restrictions on employees selling underlying shares, particularly when they need to fund the exercise price of options or to fund tax payable. But the FMCA insider trading laws do not apply to a subscription for shares or options.
The need to fund the option exercise price can be mitigated through zero exercise options, performance share rights or by allowing employees a “net-settlement” right (under which they can elect to take a reduced number of shares by offsetting the exercise/transfer price against the market value payable for the shares to fully vest).
Other compliance considerations
Other compliance considerations include:
company law constraints (for example, the regimes governing financial assistance by a company for the acquisition of shares, and the buyback of shares by a company), and
for listed companies, the requirements of insider trading laws and the overlay of the NZX Listing Rules.
Financial considerations include:
- cashflow - clearly this improves if the need for cash remuneration is reduced because of a plan
- the deferral or avoidance altogether of remuneration, where performance or similar contingencies apply
- expenditure recognition requirements, and
- impact on financial statements.
The New Zealand Equivalent to International Financial Reporting Standard 2, Share Based Payment, requires an entity to reflect in its profit or loss and financial position the effects of share-based payment transactions, including expenses associated with the granting of share options to employees. This has been a disincentive for some employers.
The standard is widely drawn and can extend to benefits provided by shareholders to employees of an underlying employer.
More recently, some employers have disclosed the non-cash employee benefits as a distinct line item in financial statements, to enable analysts to disregard the accounting charge for valuation purposes.
There are some wider implications to think about
Some of the general implications to weigh up include:
- whether, in terms of perception, it is important for employees to receive shares, or whether they will understand the equivalent (or superior) benefits for them under less "transparent" plans
- the extent of any dilution for existing owners under a plan
- whether co-ownership should be deferred
- whether employees will be disincentivised if the plan fails to deliver benefits through no fault of their own, for example, options which are "out of the money" due to a market fall. If so, a blend of benefits might be desirable.
Never forget taxation
Last, but by no means least, an employer should consider tax considerations when creating a plan. Plans have varying tax implications.
Tax on employee gain; deduction for employer
An employee’s gain between the granting of rights under a plan and vesting of full title to shares is taxable in the same way that a cash bonus would be. An employer will have a deduction of equivalent value to the employee’s gain.
Differences in an employee’s marginal tax rate compared to the employer’s tax rate will usually result in some tax “leakage”. It will be a matter for negotiation how any such difference is borne. Some employers may gross-up the benefit or otherwise agree to cover the additional tax payable.
Loans made to employees to acquire securities under a plan will not be subject to Fringe Benefit Tax if certain criteria are satisfied.
Under tax law changes which took effect from April 2017:
- Employers may choose to withhold tax using the PAYE system on employment income received under employee share schemes. The choice to withhold can be made on an employee by employee basis and is revocable.
- If an employer chooses not to withhold PAYE, the employer will be required to disclose the value of benefits employees receive under employee share schemes.
Previously, income arising under employee share schemes was not subject to tax at source (PAYE and FBT).
Plan with care
Be clear about what you are looking to achieve and design your plan carefully to maximise your chances of achieving your objectives under a win-win scenario which provides benefits both to the employees and to the business.