Employee incentivisation has never been more important than it is now. With extreme labour shortages allowing employees to leverage higher paying positions, employers need to consider rewards other than wages to encourage loyalty.
Granting equity in a business can give employees a sense of ownership, help boost their productivity and increase their loyalty to the company.
However, there are several important aspects to consider in creating your employee share scheme.
Firstly, you should think about the employees to whom you will grant the shares or option to purchase shares (‘equity interests’).
Will you be including all employees, or only a certain class?
What is the criteria for being offered equity interests?
If all of the equity interests are taken up and converted to shares, will this cause a voting imbalance in the company or a breach of regulatory thresholds?
Additionally, a scheme can obtain relief from regulatory obligations (such as disclosure requirements under the Corporations Act) if it comprises an offer to ‘senior managers’. It may therefore be beneficial to offer the equity interests only to such employees, who either make or participate in decisions affecting the whole or a substantial part of the business or the financial standing of the company.
Valuation and tax
How you value your shares will have important tax repercussions. Valuations need to be made on a yearly basis if shares are issued over multiple financial years because there will be an annual capital gains implication for the employees, as well as a need for you as employer to lodge reports with the ATO.
One consideration is that employees can obtain tax concessions where the discount on equity interests is no greater than 15% of the market value, so while you might think you are being kind to your employees by issuing interests for free, the employee might have more to worry about from a tax perspective.
Another is fringe benefits tax. By satisfying the definition of ‘employee share scheme’ in the Income Tax Assessment Act 1997 (Cth), an employer can ensure that the equity interests are not subject to fringe benefits tax.
Because of the potential unexpected consequences, it’s important to get taxation advice from you accountant or tax lawyer both when setting up the scheme and during implementation.
Types of Shares/ rights
What kind of rights do you want to give to your employees? Will you give them the right to vote at meetings?
Most founders take “ordinary” shares in a company.
Ordinary shares give holders the right to vote, the right to attend meetings, the right to receive dividends and to receive a certain amount of the surplus of assets upon a winding up.
You might think about giving employees some or all of these rights in their equity interests. However, whether or not shares are ordinary can have an impact on whether certain tax concessions are available.
In addition, while you might be happy to allow your employees to participate in the financial successes of your enterprise, many business owners might not necessarily be as happy to provide them with the fairly powerful ability to control voting outcomes at general meetings of the company.
How you calculate dividends and when you make payment is integral to the concept of incentivisation.
If you issue dividends too quickly after a financial period an employee might think: “Well I’ve got my dividend, now I’m going to shoot off and get another job”.
Conversely, if the dividend is issued too long after a financial period the employee might find the reward insufficiently immediate.
A similar incentivisation issue arises in respect of the basis of issuing dividends, which will likely be linked to the profit of the company. If the decision to issue the dividend is left to the discretion of the company the employee may see no value, while if there is little or no discretion the company might be bound to issue a dividend even where it cannot afford it.
Therefore, as with voting rights, balance is key in defining dividend entitlements.
An effective share scheme should contemplate the circumstances in which employees can transfer their interests and how the interests are going to be valued upon transfer.
Again, the design of this mechanism is an opportunity to build incentivisation. You can require employees to work a certain number of years before they are able to transfer. There should be an obligation to transfer if the employee resigns, and you might also consider a discount on the value of shares of a ‘bad leaver’, being an employee who has been fired from the company due to misconduct.
As with dividend distribution, the timing of when employees can exercise an option can be used to enhance incentivisation. For example, once employees have worked for a certain period of time they can exercise the option and the options can vest in relation to a vesting schedule.
While continued employment is one of the key requirements for the exercise of an option, as mentioned above, you should keep in mind that the length of the vesting schedule will impact employee taxation and employer reporting requirements.
Exit events include third party takeovers, listings, sales of business and reconstructions.
You should consider how your scheme is designed to operate in such events. For example, will options lapse and/or forced buy-backs occur? Will employees be forced to participate in a sale if the majority agree? In the event of a reconstruction it will be important to ensure that employee interests are converted to the appropriate holding in a new or equivalent entity after the restructure is concluded.
The scheme offer/plan is your key document. This document will consider your vesting schedule, conditions, leaver valuations, takeovers and exit events, and will also include an exercise notice.
Another key document is a shareholders agreement. If a document already exists and employees are receiving ordinary shares there will most likely need to be amendments made.
If there is no shareholders agreement one will need to be drawn up as part of the scheme documentation.
Not only will this provide certainty to founders, directors and employees about the control and operation of the company, but it will also give potential third party investors an understanding of the rights of employee shareholders.
An employee share scheme is a valuable tool to encourage loyalty and boost productivity among employees. Getting it right requires you to consider multiple issues including share rights, dividends, control, tax and third party investment.
An effective scheme will strike a balance between the interests of the business, the founders and the employees, and will involve input from legal, financial and tax advisors.