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Employee share schemes - Top 5 mistakes by VCs

Posted on November 15, 2010

Venture capitalists have a keen interest in the success of their investee companies. Usually, this depends on the initiative, drive and loyalty of the management teams. Therefore, VC investors take extra care to ensure that the members of those teams have effective, equity based incentives. Don't they?

Not necessarily. Often, the question of employee share schemes is left until very late in the negotiations and may not be dealt with properly at all. Here are 5 ways in which VC investors can get things wrong.

Failing to include enough team members

The main shareholder-directors of an investee company are likely to have a continuing interest in the equity of the business, but what about other key members of the team? Often, their needs are ignored until it is too late. The equity structure may then preclude them being offered tax-efficient incentives or indeed any incentives at all.

Shutting off opportunities for tax saving

For example, many smaller investee companies which retain their independence will normally be able to offer tax-efficient options under the Enterprise Management Incentive (EMI) (subject to other criteria being satisfied more details here). But sometimes VCs will insist that they take control if things go badly wrong. Assuming the VC is corporate, or a partnership with a corporate partner, any such provision, however unlikely in practice, will probably prevent the investee company validly offering EMI options.

Failing to consider alternatives to options

Many VCs take the view that, if EMI options are not available, employees should just get unapproved options. The resulting heavy tax bill will be the recipients' problem. But on any substantial gains, the rate of income tax may be 50% with employer and employee NICs on top, which rather defeats the purpose of the incentive. In fact there are usually viable, lower tax alternatives to unapproved options, for example the Deferred Share Purchase Plan (DSPP). If properly drafted this will ensure that gains are within the capital gains tax regime.

Imposing unnecessary performance conditions

At the end of the day, the success or failure of most investee companies is measured by the share price at exit. Some VCs seek to impose a form of double jeopardy on share scheme participants by the use of vesting conditions which make the proportion of shares over which the option can be exercised depend on levels of sale, profits or other criteria. Sometimes these criteria are very complex, and the participants may come to regard the incentives as mean-spirited and divisive.

Imposing non-dilute clauses

VCs naturally want to protect the value of their investments. Sometimes they insist on provisions to the effect that, if the company issues more equity such as additional employee share awards, the VC will not be diluted. This ignores that the fact that any new issue of equity must by definition be in the interests of all shareholders. A non-dilute clause can stifle the ability of management to offer additional incentives to existing managers or new hires. Where a VC insists on a non-dilute clause it can therefore damage its own interests.

If you would like to discuss any of the issues raised in this article, please call us on 020 8949 5522 and ask to speak to one of our advisors.

 
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