Employee share schemes: complicated by design

team building

Certainly there are complexities to be negotiated, particularly in the areas of employment and especially tax law. However, it is the attempt to resolve these technical and regulatory issues at too early a stage in the process that is the source of the problem. Before addressing these issues the scheme should first be designed to meet the particular needs and objectives of the business for which it is intended. The design drivers here are simple: who is it for, what should it provide and when should it be provided.

The who is easily identified: the beneficiaries of the scheme are the employees and, in the case of an SME, selected individuals. For most SMEs an “all employee” share scheme will be inappropriate save possibly where some provision for “collective ownership” is made through a discretionary trust holding shares for the benefit of all employees. The ability to award shares, or an interest in shares, to selected individuals and on a discretionary basis is a fundamental element of the design.

What should it provide? It is an employee share scheme so shares, or an interest in shares, would be a good starting point. The key design question here is what form that interest should take: shares (and if so what class of share) or a right to acquire shares (a share option)? The founders will be concerned to incentivise (and keep incentivised) the recipients of the share awards. They will also be rightly concerned to recover these awards where the employee does not perform or possibly chooses to leave their employment with the SME. An immediate award of shares is the provision of a reward not an incentive. It provides only a short term incentive and creates a potentially long term problem for the business if those shares cannot be easily recovered from an underperforming or departing employee. Save for very senior hires (where the role can command an immediate shareholding alongside the founders) the scheme should be based upon options – the right to acquire shares in agreed circumstances and on agreed terms.

Share options have a further advantage over an immediate award: the award under the option can be made infinitely variable. It can be linked to the performance of the individual, department, division, and subsidiary or to the company itself. What is important is not the number of shares over which the individual is granted an option but the number of shares over which the option may ultimately be exercised, that is vest, and this vesting can be linked to any performance metric that can be measured or any conditionality that can be drafted.

This leads to the final design consideration – when and in what circumstances? The economic value of any share derives firstly from the dividends paid on it and secondly from the capital value it can command on a sale or possibly a liquidation. Dividends are not routinely paid on shares in an SME (save where they form part of the overall compensation paid to the founder shareholders which they will not wish to share!). Accordingly, timing the acquisition of shares to enable the participation in dividends is an irrelevance as none are likely to be paid. The value of a share in an SME lies in the second of its value drivers: the capital return which (in the absence of a listing) will arise on an exit event such as a sale of the company (or sale of its business and subsequent liquidation). In terms of the timing of the provision of the interest (the when) although the share options must exist to provide the necessary incentive the actual ownership of the shares need not arise until an exit event. It is only at this point that value is crystallised—and performance assessed at this point can determine the extent to which the option vests and thereby the extent to which the individual employee participates in the value crystallised. The final element in the design of the scheme should therefore provide that the option may only be exercised on an exit event and then only to the extent that predetermined performance targets have been met such as to permit the option to vest.

To conclude, the essential design elements of an SME’s share scheme should consist of the discretionary award of share options granted subject to vesting (performance) conditions which may only be exercised on an exit event as defined. As Groucho Marx might have said “A child of five could understand this. Quick, send someone to fetch a child of five”.

Neil Simpson, Tax partner, haysmacintyre