Often small business owners end up in conversations with key members of their team about rewarding their efforts with equity in the business. Giving key staff “skin in the game” can be a fantastic way to reward effort and loyalty, not to mention increase staff retention.
Disclaimer: Before you start these conversations I’d strongly recommend that you read this post. It’s all too easy to get swept away in the excitement of locking down a staff member with equity without thinking carefully through all of the options and ramifications. Slow down, read the post, speak with your advisers. Do this before talking to anyone in your team.
An employee share scheme is a scheme (duh) that sets out a legal structure under which eligible staff members can acquire equity in your business. It is one way (of many) of rewarding staff and one way (of many) to give equity to a staff member. There are quite a few things to consider when looking at employee share schemes; let’s take a look at some of them now.
First up, do you really want to jump straight to equity? There are a few other options available to you. Think of these as delaying the wedding in favour of a longer engagement.
- Profit share. You can pay the employee a bonus that reflects a percentage of your profits. Easy to establish, easy to understand, but may not be as good as equity fo retention. Think about how much cash you need to retain to pay tax, ensure working capital is sufficient and pay your own dividends when figuring out the % to award staff.
- Phantom equity. This is still essentially a bonus scheme, but it’s tied directly to the financial outcomes attached to the shares on hand. Say you’re the sole shareholder and you have a team member on a phantom scheme, they might get a bonus equal to a % of any dividends you get, or a payment equal to a % of sale proceeds if the business gets sold. Easy to understand and establish, but not very effective from a tax perspective for the team member. It’s also not quite as effective as equity from a retention perspective.
- Flowering shares. These are a little complicated, but essentially they are shares without rights (i.e. no voting rights, no dividend rights, no capital rights, etc.). As time goes by and the employee hits certain performance hurdles and/or employment anniversaries then rights will begin to attach to the shares. These schemes can be effective, though they are a little fiddly.
Let’s say none of the above will do. You could issue options under what is commonly referred to as an ESOP (employee share option plan) so the staff member can purchase the equity at a time that suits then (often just before a sale event). In case you don’t know, an option is a legal agreement to buy (or sell) something (in this case, shares) for an agreed amount sometime in the future. Typically they are issued with an expiry date. An option gives the employee some surety without them having to actually buy anything just yet.
Or, you can go straight to the finish line and issue equity to the team member. This issue of equity could take the form of:
- New shares in the company. An employee share scheme typically refers to a scheme under which new shares are issued by the company. This can be great if the company needs cash as the purchase price paid by the employee ends up in the company coffers, or
- Selling some of your shares. The employee could simply buy some shares directly from you (and/or your business partners). This is commonly referred to as a management buyout. Can be effective if the company doesn’t really need the cash and the owner is looking to ‘de-risk’ their position by exchanging some shares for cash.
There are many ways to skin this particular cat. Regardless of which way you go, here are some critical issues to consider before rolling anything out:
- Tax. If you sell shares to an employee you’ll have Capital Gains Tax to worry about. If you give an employee shares at a discount to market value then the employee will have Employee Share Scheme tax issues to worry about. Tax is inescapable, but it can be managed with the right advice and the right planning.
- Funding. Often the employee won’t have the dough sitting around to buy shares at market value, so it’s important to think about how they’ll find the acquisition. Vendor financing can be an effective way of handling this, but there are various tax issues to be wary of when setting this up.
- Timing. Is there some a big sale event you’re building up to? If so, the employee will want to have their equity locked down before that happens. If there are no big plans on the horizon, it might give you time to allow for the shares to vest over time.
- Dividends vs capital growth. Is the employee taking an equity stake for a steady revenue flow coming from dividends, or are they in it for the capital growth that would be realised on sale if the business has grown since they received shares? It’s important to understand everyone’s motivations behind wanting equity to ensure the scheme is tailored to meet those expectations.
Lots to think about! This is your business, something you’ve no doubt put a lot of blood, sweat and tears into, so don’t rush into giving any of it away. Take your time and get the right advice before starting any conversations with employees.
If you’d like to have a chat with one of our experienced advisors about a scheme for your business, why not get in touch today? We’ve helped plenty of business owners get equity into the hands of their employees and we’d love to chat with you about how we can help your business too.