A method of encouraging employees to make decisions like business owners is to go ahead and make them owners!
Employee ownership is achieved through the implementation of employee share scheme where employees are awarded partial ownership in a company as part of their remuneration package. It’s based on the premise that if an employee can make key contributions toward business success, they will be rewarded with their equity increasing in value.
While employee share schemes in a listed environment are common, private companies are increasingly looking at ways to enhance their reward programs to create “skin in the game”.
Our work with private company clients in this area cites a number of specific reasons for looking at employee equity as a long term incentive plan (LTIP), including:
- Owners wanting to sell down their shareholding and transition toward retirement
- Companies seeking to increase productivity and engagement from employees
- Companies seeking an equity alternative for payments based on the cashflow impact of the pandemic
Designed effectively, equity incentives for employees of private companies can achieve the desired “owner” mentality.
Here are some key areas to consider when looking to implement a long term equity plan for private, unlisted entities.
What is the objective?
The company’s vision sets the overall framework for the LTIP, clearly outlining the long-term objectives and behaviours required. For example working toward transitioning ownership in the future or an IPO.
Understanding the objectives will impact the design decisions including the equity instrument (e.g. options, performance rights), performance metrics, vesting schedules and approach for liquidity events.
Typically the objective of a long term incentive plan (LTIP) is either performance and/or retention related. This has implications on the design, in particular the equity instrument.
Performance focused companies looking for growth may look to leverage vehicles such as options and share appreciation rights (SARS). Alternatively, those companies wanting to emphasise retention may look at full value equity vehicles such as performance rights and performance shares.
Who should participate?
Typically, participants in long term equity schemes are the key talent in the company. While roles and titles will vary from organisation to organisation, it’s those who can influence strategic drivers to increase enterprise value. Contemplate whether or not it would be valuable for a particular role or employee to be invested in company outcomes on a long term basis.
Should performance measures be used?
Whilst some equity schemes are based purely on retention (i.e., stay for three years and receive shares) to encourage long term behaviours and outcomes, specific performance measures may be designed. Depending on key business objectives, some organisations may find it appropriate to use KPIs, while some may find it more appropriate to place a greater emphasis on employee behaviours. Realisation of financial goals or project outcomes are one way to measure success, or personal attributes such as adaptability, team building and problem solving may be the key behaviours your company is seeking from employees.
Whether it’s a matter of shifting the weighting or introducing new evaluation criteria, consider whether the performance metrics align with business objectives.
What are some alternative structures?
Issuing ‘real’ equity in the Company has substantial consequences which can be both positive and negative. The potential impacts of parting with some ownership control and diluting earnings are very real issues and often are the immediate focus for LTIP design.
Whilst there are a number of benefits for using actual equity, it is relatively common for private companies to use a cash equivalent such as ‘phantom’ equity. These equity-like instruments link payouts to growth in company value and settle in cash which can reduce some of the complexity associated with issuing physical shares.
For private companies a loan funded share plan can be a simple, tax effective arrangement for rewarding their employees with equity. Loan share plans can provide an employee with full equity in the business without any upfront tax cost. An example of a loan share plan is as follows (see illustration):
Loan Share Plan – An Example
Under this arrangement, the employee shares in future dividends paid by the private company and benefits from any increase in value of the shares without any outlay of funds. The employee has little or no ‘downside risk’ due to the limited recourse nature of the loan (albeit in some circumstances a minimum loan repayment might be required to ensure the employee has some ‘skin in the game’).
The non-tax considerations for this sort of employee equity arrangement are very similar to those for a vanilla employee share schemes including requirements when offering securities under the Corporations Act 2001 (CA 2001), determining the value of the share and other governance issues. While there are restrictions imposed by the CA 2001 in relation to a company providing financial assistance to a person to acquire shares in the company, there is an exclusion for financial assistance in respect of an employee share scheme (i.e. “exempted financial assistance” Section 260C CA 2001).
When can shares be “cashed out”?
For most private companies the ability to ‘cash out’ LTIP shares is limited to an event (e.g., IPO, transaction). This is important to clarify in the design as the implications may impact participant engagement.
Providing access for participants to sell shares during employment is typically not available as it is incongruent with the intention of the plan and it may impact company financials.
What about tax, accounting and valuations?
It is critical to ensure that the participant is not taxed on equity prior to the time they are able to effectively dispose of all or some of the shares to cover any tax liability. Concessions are available which may defer or reduce to nil the income tax obligations for the employee. The accounting treatment of the equity grants needs to be assessed up-front to determine the impact on the financials. Modelling can be helpful for this. A company valuation to determine the LTIP value will be required which some companies manage internally (e.g., multiple of EBITDA) or seek external periodic valuation by a third-party.
Who will administer the plan?
When implementing a LTIP, private companies will need to consider adopting some of the same approaches used by listed companies to ensure success through appropriate risk management controls.
For example if a Board is in place for a private company, this can be used for approval purposes with administration (e.g., performance monitoring, plan participation) assigned to a management group which may include HR or Finance representatives reporting to the CEO.
How to promote and encourage participation?
The success of the equity plan will largely depend upon the value the employees place on it. The rationale, performance hurdles and equity outcomes must be communicated clearly at the time of offer, with regular updates (e.g. tracking toward vesting). This is imperative for maintaining employee engagement with the program.
The Reward Practice is an independent consulting practice that assists companies in designing tailored remuneration plans.
Contact us for more information on how a well designed incentive plan can elevate your company’s performance.