Employee Share Schemes, Is Simple Always Better?

Posted by admin at 15:51 on 13 Feb 2017

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In terms of motivating and incentivising employees, it is probably safe to say that everyone is in agreement: keeping it clear, simple and understandable is the best approach to take to ensure the incentivising measures are successful at engaging employees and achieving the company's overall corporate objectives. Regardless of what incentive is being used, be it a cash bonus scheme, commission based sales awards, or an employee equity plan, it is vital that these three golden rules are followed:

• Provide clearly defined goals: It is of the utmost importance to ensure that it is clear what is required from employees in order for them to attain their rewards. The ultimate rule here is to ensure that these goals, whilst challenging, should also be attainable.

• Understand what motivates your employees: What motivates employees will undoubtedly vary from person to person. It is important to recognise this in order to ensure that any incentive arrangements are used to their full potential.

• Be open with your communications to employees: Whilst it may be obvious that communicating the success of a company will have a motivating effect on employees, it is also vital to ensure that employees are not 'kept in the dark' in terms of any difficulties that the organisation is facing. It is only through sharing a problem that your employees will be enabled to help come up with a solution.

Behind the scenes, however, simple is not always necessarily better.

To illustrate this point, take this example of a simple, 'off the shelf' employee share scheme, designed with simplicity and cost-cutting in mind throughout the implementation process.

Say, for example, the 2 founding shareholders of an entrepreneurial business who currently own the company 50:50 want to provide equity awards to incentivise and reward three members of the company's key management team. This company has experienced significant growth in recent years and that has been due in large part to the contribution of these star employees. It is hoped that by providing equity awards, these individuals will attain recognition for their outstanding achievements, and their newly formed sense of ownership will encourage them to help the company continue along its upward trend towards the ultimate commercial goal of an external trade sale or flotation.

One way to achieve this is by implementing a highly flexible and tax advantageous Enterprise Management Incentive (EMI) share option plan, which grants the chosen employees the right to purchase shares at a price set at date of option grant. As these key people have already made a significant contribution to the company's recent success, the current shareholder would like to give them the opportunity to exercise options immediately and acquire shares.

In the spirit of keeping things simple, the company opts for an 'off the shelf' EMI plan. Under this model, these three employees are granted options over shares amounting to a combined total of 15% of the company's share capital, at 5% each. In order to enhance their levels of engagement and the feeling of ownership, it was decided that options would be granted over the same class of shares held by the founding shareholders ('A Shares'). By adopting this approach, the company will also save costs when implementing the scheme.

At option exercise, the founding shareholders' combined equity stake is diluted to 85% but this still allows them to retain a clear majority over the new shareholders.

So far, so good. How can it go wrong?

Depending on the ultimate goals of the company, it can of course be appropriate to allow employees to exercise their options and acquire shares immediately. As there are now additional shareholders, however, there is a potential for complications to arise where the original shareholders have not sought professional advice in order to safeguard against future threats. The scenarios outlined below highlight some of the areas that could cause havoc in the company.

Scenario 1:

As the original shareholders have retained 85% of the share capital, representing an outright majority, they are each under the impression that ultimate control over any key decisions will remain in their hands. An interesting opportunity has since arisen that would, as far as one of the founding shareholders is concerned, greatly improve the prospects of the organisation. In taking this opportunity forward it is necessary to secure majority shareholder approval.

The other founder shareholder is uncomfortable with the prospect and is not willing to vote in its favour. Where such disparity of views occur in a 50:50 holding position the result is deadlock but where, as is now the case here, other shareholders have the right to vote it is evident that the real control actually rests with the new shareholder employees and their decision on how to cast their vote for or against the proposal.

Solution:

When it comes to matters relating to company shares, particularly in relation to entrepreneurial companies, the question of control will often take precedent.

Had the company taken specialist advice when implementing the share scheme, advice would have been provided in relation to the issue of control, not only in the here and now, but in terms of any potential future implications for the company and the founding shareholders. When making equity awards it is vital to pay careful attention to the level of equity being awarded, and our blog here provides further detail in this regard.

One of the key benefits of an EMI is that under this arrangement it is permitted to grant options over a special class of restricted shares. Therefore, one potential solution to avoid a scenario such as that described above would be to create a new class of 'B Shares' and to use these shares in order to make awards under the EMI. These 'B Shares' can have restricted voting rights attached, meaning that the employees would not be entitled to voting rights. In the past much attention focused on the need to have 5% of the voting share capital to facilitate entitlement to Entrepreneurs' Relief but post Finance Act 2013 this is no longer required for EMI see here. Any decision to use restricted shares for EMI also needs to be considered in the round and if EIS investment has recently been obtained then this course of action may not be advisable see here for our blog on the trap to avoid on that score. A new class of restricted shares for employees may also place restrictions on the rights to dividends for those holding that particular class of share. This is often desirable when it is considered that it may not be entirely appropriate for employees to have an entitlement to the same level of dividends as the founding shareholder. Typically there will be Board discretion over whether and at what rate per share dividends will be paid for each share class.

Other solutions might include having the options only capable of exercise on an exit event (which is simple but would not then give the key employees any opportunity to participate in profit share by way of dividend which might otherwise be available to them if they were shareholders earlier) or making sure a separate Shareholders' Agreement is implement to set out a new set of rules governing how shareholder decisions will be taken and whether, regardless of voting rights, certain key decisions still require the unanimous agreement of both founders. Any option plan can then state that an employee must, as a condition of exercising an option, sign up to the Shareholders' Agreement and be bound by its terms once the employee is a shareholder.

Scenario 2:

After exercising options representing 5% of the overall share capital and becoming a shareholder, one of the employees has received an attractive job offer from a competitor firm. Although relations have been amicable, this individual does not agree to sell his shares back to the company when he receives a voluntary offer to repurchase the shares at his departure.

The company is now faced with quite a significant problem. First and foremost, the company is now effectively partially owned by a competitor. This can cause problems for a number of reasons. As a shareholder, the departed employee will still retain his right to for example, inspect the Minutes of any general meetings (thus potentially providing a competitor with valuable information about the company), and to participate in any rights or bonus issues.

Solution:

By engaging a specialist firm to implement the share scheme, the founding shareholder would have received advice in relation to the treatment of employees who leave the company. The terminology that is typically used draws a distinction between what are commonly known as 'good' and 'bad' leavers.
What determines a 'good' or 'bad' leaver is up to you and usually, the share scheme plan rules would stipulate that there is ultimately Board discretion over 'good' and 'bad' leavers. Please note that option plan rules only govern the relationship between the Company and the option holder, and once the option has been exercised the document governing the relationship between the Company and the shareholder is the Articles (and any Shareholders' Agreement to which they are bound to comply) so these often need to have mirror provisions introduced. The Articles are of course a public document so if you wish provisions to be made in a side agreement then a Shareholders' Agreement may be required.

For any individuals who have not yet exercised options, and who have been determined to be a 'bad leaver', options would usually lapse. In the event that an individual is determined to be a 'good leaver' (for example, in the case of illness), the company may wish to allow him/her to exercise a certain proportion of their options and acquire shares.

Where employees have been enabled to exercise their options and become shareholders it would be necessary to include provisions in either the Articles of Association or a separate Shareholders' Agreement in order to outline the treatment of 'good' and 'bad' leavers. For example, it is possible to include a compulsory transfer provision that states that any shareholder would be obliged to sell their shares back to the company on cessation of employment and that a different sale price would be offered depending on whether the individual was deemed to be a 'good' or 'bad' leaver.

'Drag along' provisions can be included in the Articles / shareholders' agreement that ensure no minority shareholders (for example, those individuals in the above scenario who have been allowed to exercise options and now collectively hold 15% of the share capital) can refuse to sell their shares. These rules can ensure that minority shareholders are forced to sell their shares in the event that the majority shareholders decide to sell theirs, as naturally most acquirers will be keen to acquire the whole ownership and not have legacy minorities to deal with in the future.

Comfort in a specialist approach.

Please do not be discouraged by the 'worst case scenario' events that have been described above. Whilst there are a number of pitfalls that any company must be wary of in relation to issues of control when making equity awards, the above solutions highlight how these can be avoided with the help of a specialist team whose job it is to remain vigilant of such concerns and pre-empt all the 'what ifs'.

One of the major benefits of using a share incentive plan such as an EMI, is the flexibility that is permitted in terms of any conditions associated with awards, as well as the rights and restrictions attached to shares once employees have been allowed to acquire them. This high degree of variation allows any company implementing an EMI to ensure the plan effectively aligns with the three 'golden rules' of employee motivation listed above. Implementing a slightly more complex model, in which, for example, clearly defined and achievable performance conditions are attached to to awards can have a significant impact upon the overall direction and growth of the company. These performance conditions can be tailored specifically for each individual participant.

Understanding the most appropriate way in which to motivate employees to achieve corporate objectives is a vital component of any incentive plan. In the above worked example, where the ultimate goal was an external sale of the company, the founding shareholder may have considered using 'exit only' exercise conditions for options in order to encourage the retention of his key employees up until the point of sale. This would also represent a relatively simple and cost effective share plan in terms of its implementation. In the event that employees are able to acquire shares, major shareholders should be highly cautious about being caught out in relation to any unnecessary loss of control that could potentially have a severe impact on their desired direction for the company.

If you would like to learn more about how RM2 can help to design an incentive plan that works for you, please contact kerrie.willis@rm2.co.uk, or call 020 8949 5522 to speak with one of the team.