Incentivising Employees with Equity: What Are Your Options?
Incentivising staff with equity is a common issue for businesses of all sizes. We commonly assist our corporate clients with understanding, structuring and implementing equity incentive plans. This article looks at some of the various structures that may be available to your business and our insights on when those structures are (and are not) appropriate.
Employee Share Schemes
Employee share schemes, more commonly known as ESOPs, enable a company to issue shares or options to acquire shares to employees and contractors. In Australia, ESOPs are legislated for under the Income Tax Assessment Act 1997 (ITAA) and the Corporations Act 2001 which, when complied with, provide certain tax incentives for ESOP participants. These include the ability to defer the income tax assessable in relation to any discounts provided on shares issued under the plan, as well as an entitlement to a CGT discount on disposal of the shares.
Implementing an ESOP is not a straightforward process. There are specific rules under the ITAA which need to be complied with for a participant to qualify for the tax benefits.
Among other things, this includes the requirement that the ESOP does not result in any individual shareholder holding more than 10% equity in the company (for a more comprehensive list of requirements, see our previous article). As such, ESOPs are generally not appropriate for larger shareholders.
An ESOP might be appropriate for your company if:
- you are looking to issue less than 10% equity to one or more staff;
- you are looking to minimise the amount the staff must pay the company in consideration of the equity while leveraging available tax exemptions.
Vesting and Reverse Vesting
If you’re looking to issue more than 10% or are otherwise unable to comply with the ESOP requirements under the ITAA, you may wish to consider a vesting arrangement. Under this arrangement, the employee’s entitlement to equity is only triggered when certain criteria are met, such as a minimum period of employment or certain milestones being achieved. On the satisfaction of a vesting condition, the employee is entitled to a parcel of equity.
For example, a vesting arrangement might say that the employee receives a quarter of their equity entitlement each year over four years. At the end of each year, 25% of their total equity entitlement is issued.
While this can be useful, a straightforward vesting arrangement can:
- create tax consequences for the employee - each year the company’s value will (hopefully) increase, so the employee will pay higher income tax on each grant of shares; and
- create more admin, as the company needs to go through a share issue process on the satisfaction of each vesting condition.
These issues can be resolved with a reverse vesting regime pursuant to which:
- the equity is issued on day one, however it is issued as unvested;
- while the shares remain unvested, if the employee quits or is fired, the company can require them to forfeit the unvested shares for a nominal sum.
- as the vesting conditions are met, unvested shares become vested shares, and the risk of forfeiture falls away.
This results in the employee only paying income tax based on the company’s value on day one and reduces the admin of having to process multiple share issues.
Phantom Share Plans
When it comes to incentivising employees, we often find that non-equity approaches may be more suitable. It is not unusual for a client to want to consider alternatives when faced with the complexities and steps required for equity arrangements such as ESOPs and vesting. Keep in mind, if the intention is simply to increase an employee’s monetary entitlement, this can be achieved without equity.
While there are always the commonplace commission plans and bonus schemes (see our earlier article for more on this), if you want a plan which emulates ownership without actually giving away equity, you may wish to consider phantom shares. These are contractual rights which simulate the financial benefits of owning shares in the company.
There are two common types of phantom share plans (PSS). The first, which we generally don’t recommend, is one in which the employee is entitled to a cash bonus equal to the company’s growth in value:
- An employee is granted phantom shares in the company. Each phantom share represents one share in the company.
- Each year, the employee is entitled to a bonus which is equivalent to the increase in value of shares in the company.
- So, if on the date of grant a share in the company is worth $100, and after a year a share is worth $150, the employee is entitled to $50 for each phantom share it holds.
The issue with this type of PSS is that an increase in share value isn’t always reflected by an increase in available cash. For example, if share value increases due to acquisitions of land or market fluctuations, this doesn’t necessarily mean the company will have that cash available for distribution.
The second type of PSS, which we prefer, is one in which a phantom shareholder has a contractual entitlement to be paid an amount equal to any declared dividends. For example, if the employee holds 10 phantom shares, and the company declares a dividend of $100 per ordinary share, then the employee is entitled to $1,000. The benefit of this approach is that bonuses are only payable to PSS participants alongside dividends, giving the company more control over the flow of funds.
A PSS may be appropriate in circumstances where you want to provide a financial incentive to an employee tied to the performance of the company without granting ownership.
Need more help?
Our commercial and corporate lawyers have ample experience helping business put in place various incentive plans, both equity and non-equity based. If you want to incentivise your employees but don’t know where to start, you can see our contact details below.
