Employee share schemes for private companies By William Buck on 01/09/12 - Mins to read: 4 minutes Employee share and option arrangements are recognised around the world as a unique and effective way to attract, retain and motivate employees. The principle is simple: by making the employees shareholders of the company, the interests of the employees and the shareholders are aligned, achieving greater benefits for the company and a sharing of these benefits with the employees. Many Australian public companies and multi-nationals operating in Australia use employee share schemes. However, employee share schemes are not just for large companies. Private companies, large and small, can also achieve significant benefits. They just need to approach things a little differently. We have designed and implemented employee share schemes for numerous private companies. The most common scenarios are: Exit strategies: The business owner is looking to exit by way of a sale or IPO. The employee share scheme is used to “lock in” employees and focus them on maximising the value of the business. Succession plans: The business owner wants to step away from the business. The employee share scheme is used as a tool to retain and reward the key executives who will take over management of the business. Start ups: The business owner wants to attract the right skills but there’s limited cash. Offering the right people a share in the future success of the business can be an effective strategy. What makes a private company employee share scheme different? The fundamental difference between a private and public company share scheme is in the market for the shares. In a publically listed company, the employee can sell the shares on the stock exchange. This makes it clear how much the shares are worth and enables employees to convert shares to cash to cover tax liabilities. In a private company, there is no ready market for the shares. This means: There is less certainty around the value of the shares. This can negatively affect the employee’s perception of the benefit of holding the shares. It also introduces additional compliance costs as valuations may be needed for tax and accounting purposes. It’s harder to fund the tax liabilities. The difference between what the shares (or options) are worth and what the employee pays for them (termed the “discount”) will be taxable to the employee. In a private company the employee can’t readily sell down some of their shares to fund this tax liability. If the tax implications aren’t managed, the employee share scheme can quickly turn from a real positive to a real negative. Ex – employees? Having ex-employees as shareholders in a private company is something most businesses want to avoid. There are mechanisms – vesting conditions, good leaver/bad leaver provisions, variation of rights – which can be used to manage this situation. Designing your plan The first step in designing your plan is to identify what you are trying to achieve. What are your commercial objectives? For example, in the case of an exit strategy you may be looking to: Maximise the value of the company to get the best price on sale, and Lock in key employees and focus them on working towards the sale In this situation, the design of the plan should consider: The importance of dividends – An effective employee share scheme might be based around a class of shares that doesn’t get dividends but does share in any future gain on sale. Conditions for an employee who leaves before sale (three years into a five year plan for example). Vesting conditions could be used so that those employees who don’t stay the distance forfeit their shares. The tax implications for employees – choose the class of shares carefully. Shares with limited rights will generally have a lower market value than ordinary shares. A lower market value should lead to a lower tax liability. By tailoring the share scheme to focus on commercial objectives, we can go a large way to addressing the private company issues. The tax implications Employee share schemes are either taxed “upfront” or “deferred”. The tax treatment will depend on the design of the plan and not on any election made by the employees (which was previously the case). For share schemes that are taxed upfront, an income gain is taxable when the scheme is entered into. Any future growth in the value of the shares will be taxable as a capital gain and will benefit from the 50% capital gains discount as determined from the upfront taxing date. For share schemes that are tax deferred, some or all of this future growth in value will be taxable as an income gain at a later vesting date. It is only any growth in value after this date that may be taxable as a capital gain and will get the benefit of the 50% discount. A key driver of the taxed “upfront” or “deferred” classification is whether there is a real risk that the employee will forfeit the shares or options. If there is, the plan will likely be taxed deferred. This makes designing the right forfeiture and vesting conditions to deal with ex-employees critical. Employee share schemes are not the only incentive and remuneration strategy available to businesses. A well designed bonus plan can achieve many of the things that a share plan does. There is something about the “ownership” element of an employee share plan, however, that makes it special and often produces a result beyond what cash bonuses can do. If employee share schemes or other incentive arrangements are of interest to you, please contact your local William Buck advisor to discuss how we can help.