Employee Share Schemes - How Many Shares?
Employee share schemes work by aligning employee interests with those of shareholders, so helping to maximise shareholder value. The tax and cash flow savings can also be attractive, but how should companies decide how many shares to offer?
Whatever the scheme, whether it be an option scheme, deferred share purchase or shares gifted in trust, choosing the right level of equity is vital. Offer too much and shareholders lose out since the same effects could have been achieved with less dilution. Offer too little, and equity is wasted again. Shares have been offered but the results in terms of motivation, retention and/or attracting key new people may not be obtained.
In reaching the right judgment, several issues need to be considered:
1. What will the incentive mean to recipients? Arguably, this is most important issue. Account must be taken of a variety of factors such as recipients earnings, bonuses and aspirations. The age of recipients may be important. The prospect of a six figure sum may be more than enough to motivate a middle ranking production manager nearing retirement, but far too little to interest a highly paid city executive.
2. The impact on the company and its shareholders. There may be a practical limit to the number of shares that can be offered by a company for employee incentives, whether directly or under option. A large share issue could result in unacceptable dilution to existing shareholders or disturb the balance of control. A key principle is that shares should not be offered at all unless, by so doing, the value to existing shareholders is likely to be increased by more than the dilution they will suffer.
3. The tax treatment. The default tax position is a charge to income tax at the highest rates on any share scheme gains to employees. If nothing is done, any serious level of incentive will result in a charge to income tax at the highest 50 per cent. rate plus (in most cases) national insurance contributions both for the recipient and for the company. However a variety of tax efficient schemes are available, both government sponsored and unapproved, which ensure that gains are subject to capital gains tax at much lower rates. In certain circumstances, employees may benefit from Entrepreneurs' Relief resulting in a tax rate of just 10 per cent. with no NICs to pay.
Clearly, the better the tax treatment, the smaller the number of shares needed to offer a net level of incentive.
4. The regulations do they matter? It seems that dozens of regulatory bodies, from the Financial Reporting Council to the Association of British Insurers, now have opinions on how much equity companies should offer for incentive purposes, and in what manner. A detailed analysis of these rules will be the subject of a future article. Suffice to say that common threads include (in very broad terms) a rolling limit of 10 per cent. of share capital, phased vesting and stretching performance conditions. There are a large number of more detailed stipulations. Fortunately, unquoted companies need pay no heed to these strictures. Refreshingly, also, many quoted and listed companies are now choosing their own solutions based on commercial needs rather than the opinions of self-appointed regulators.
If you would like to discuss any of the matters raised above in more detail, without cost or obligation, please call us on 020 8949 5522 and ask to speak to one of our advisers.