What Is An Employee Share Scheme?

11 April, 2019 | Bret Gower

We are occasionally asked to assist clients with the formation of an employee share scheme (“ESS”). An employee share scheme is a legal structure a company can use to give or sell shares in the company to its employees. Client’s reasoning for forming an employee share scheme can vary depending on the type of business and the stage the business owners are at in the life-cycle of their business.

What is the purpose of an employee share scheme?

Objectives for establishing an employee share scheme can often include:

• 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.

Employee share schemes are considered effective by some employers because the longer duration vesting terms of the shares linked to continued employment can ‘hand-cuff’ an employee to stay with a business in a way that shorter term incentives cannot.

Potential issues with employee share schemes

Potential issues that arise in relation to employee share schemes include: the tax treatment of benefits provided to employees; the complexity or otherwise of the scheme; and, the ability of the business to link performance to benefits provided.

Compliance may also be required with the Financial Markets Conduct Act which regulates the issue of shares to members of the public and employees.

Different Types of employee share schemes

There are a range of different types of employee share schemes, each with differing benefits to employers and employees and some more suited to large or high growth companies. Generally, the tax implications for the business with these types of scheme are low depending on how the schemes are structured.

Employee share loans (ESL)

In this structure the company provides a loan to employees to buy shares at market value and often the loan is repaid to the company by applying the dividends that accrue from the employee’s shares. The loan may or may not be interest-bearing.

The valuation of the shares is based on the value of the underlying shares at grant date and the complexity of these types of scheme is relatively low, unless the company has issued put/call options on the shares.

A put option gives the holder of that option the right to sell the shares at a predetermined price (the strike price) until a predetermined date (the expiry). Alternatively, a call option gives the holder of that option the right to buy the shares at the strike price by the expiry date.

Partly paid shares

In this type of scheme the company grants the employee partly paid shares. The outstanding payment amount for the shares can be called by the company at a later date.

As with employee share loans schemes the valuation of the shares is based on the value of the underlying shares at grant date and the complexity of these types of scheme is relatively low, unless the company has issued put/call options on the shares.

Different share classes

In this type of scheme the company grants the employee shares at market value with different rights, for example the shares might exclude voting rights yet entitle the shareholders to receive dividends.

The shares are valued according to the value of the underlying shares at grant date. This type of scheme is moderately complex in both the initial implementation and the ongoing administration of the scheme.

Performance rights

Here the company grants the employee shares once specified performance hurdles have been met and consideration for the shares can be nil or negligible.

In this type of scheme the company values the share rights at grant date together with the value of the underlying shares.
The right to be granted shares will usually have an expiry date and the complexity or otherwise will largely depend on the terms of the scheme.

Options

The company grants employee options to buy shares at a future date at a specified or bench-marked value.

In this type of scheme the company values the share options at grant date together with the value of the underlying shares. The right to be granted options will usually have an expiry date and the complexity of this type of scheme is moderate to high in both the initial implementation and the ongoing administration of the scheme.

Phantom share schemes

Company provides the employee with a cash payment which is referenced to the company’s share price. This is not a true shareholding by the employee but effectively a bonus tied to the share price performance.

Valuation in this type of scheme is based on the value of the phantom options at grant date together with the value of the underlying shares, and implementation and administration complexity is moderate to high.

Employee share scheme as a way for shareholders to exit

Liquidity in closely held companies is often problematic because the timing of employees wanting to become shareholders often does not coincide with timing of the exit by existing shareholders. In our view an employee share scheme does not necessarily alleviate this problem for the following reasons:

• Employees will want a dividend stream in return for their investment in the business – which is effectively paying a bonus – and to which shareholders would be entitled to whether the employee has exceeded expectations or not. An employee share scheme does not remove the complexity of measuring employee performance, regardless that the intention is to incentivise employees
• Because most employee share schemes involve payment over time the dividends that otherwise would be received by employees are applied in payment for shares, so that the only benefit to employees is the hope that the share value will grow and that they will receive benefits in the future.
• The effect of an employee share scheme will be to postpone the problem of senior shareholders selling shares to another generation of owners of the Company, because all employee share schemes by their very nature require a finite term so that new employee-shareholders know when they will be able to sell out, and often the only purchaser at that time will again be the company or other shareholders.
• If a company issues shares through an employee share scheme, the company may be unattractive for merger with or acquisition by another business due to the burden of the employee share scheme.

Over many attempts with clients pursuing employee share schemes very few have been successful due to the mismatch between the timing of employees’ exit from the company and the company or other shareholders’ obligation to buy those employees’ shares at that point. While we are neutral about the benefits of a company’s implementation of employee share schemes we consider it essential to assess the merits of an employee share scheme in relation to each client’s circumstances on a case by case basis.

In considering an ESS clients must at all times remain mindful of their obligations as employers, and if implementing an ESS must recognise the interaction between ESS’s and employment agreements (and the need to put that interaction in writing).  We recommend you take expert advice from one of our experienced employment lawyers in this regard.

If you have succession planning issues or wish to discuss employee share schemes or other employee incentive schemes please contact NZ commercial lawyer, Bret Gower by phone on 09 837 6893 or email bret.gower@smithpartners.co.nz