WHY SHOULD WE BE THINKING ABOUT SHARE INCENTIVES?
Motivating key staff to stay and grow your business should be central to your strategy, whatever your long-term goals – and that’s where longer term share-related incentives play a key role.
If you’re thinking ahead to exit, it will also be essential for any buyer to see a clear and effective share-linked incentive program in place for the right people, over and above any annual bonus scheme you operate. This should reassure them that the key players will be properly incentivised to stay on right up to the exit – and potentially even afterwards, if selling shareholders will participate in an earn-out payment mechanism or swap some of their shares for shares in the new owner.
WHO SHOULD WE ALLOCATE SHARE INCENTIVES TO, AND HOW MUCH?
An equity stake will be appropriate in many cases for top level management. The size of the equity pool and how you allocate it will be unique to your business – depending on factors such as how much shareholders are willing to give away, how many key employees you have and how important each one is relative to each other. You may want to keep something back for new joiners.
Beware of promising employees fixed percentages – employees will need to be diluted by any future investment as well as any other employees receiving shares, just like everyone else on the cap table. It’ll be important to be clear in any conversation about percentages that this means the percentage of today’s cap table and whether this is calculated on a fully diluted basis, and to translate that percentage into a fixed number of shares at grant.
WHAT TYPE OF SHARE INCENTIVE SHOULD WE USE?
If you can qualify to grant Enterprise Management Incentive (EMI) options to your UK employees, these will give you all the advantages of using share options over upfront equity, combined with unrivalled tax savings. Their praises really can’t be sung too highly if you can meet the criteria.
If an exit is your ultimate goal, linking the ability to exercise the options to the exit (exit-only options) also avoids issues associated with employees becoming shareholders while you’re running the business – including having to get the shares back from them if they do leave.
If EMI options aren’t available, there are some tax efficient alternatives, including HMRC-backed Company Share Option Plan (CSOP) options, hurdle shares and nil-paid shares. Each has its own pros and cons, and these will need to be weighed up in light of your objectives.
For some companies who can’t use EMI options, simple non-tax advantaged share options will ultimately be the right way to go – for those, the gain realised on exercise is taxed to the employee in the same way as a cash bonus. Companies might take a split approach if they’re distributing share incentives more widely, such as growth shares or nil-paid shares for the most senior management, and share options for the next level down.
WE OPERATE A GROUP – WHICH COMPANY SHOULD THEY RELATE TO?
It’s usually best to grant awards over the shares in the top parent company (Topco), unless there’s a compelling reason not to. Some groups operate different businesses in different subsidiaries, and if there’s an intention to exit a particular subsidiary in future, this can be a reason in favour of localising the share awards for that company.
Otherwise granting awards over shares in Topco has the benefit of aligning your employees’ interests with those of your shareholders, and will enable them to sell their shares directly to any buyer in the same way. You could consider attaching additional performance conditions to the share awards that relate to a particular section of the business. Plus, tax advantaged EMI options and CSOP options can only be granted over shares in an independent Topco, and you’ve got more of a shot at being table to take a corporation tax deduction for the awards too.
WHAT IF WE JUST CAN’T USE ACTUAL SHARES?
You could instead grant employees cash awards that are linked to the value of the company’s shares, or to some other performance metric.
Cash awards based on the company’s share price performance are often referred to as “phantom share awards” or, if a hurdle is attached to the award, “phantom share option awards”. Phantom share plans can be very flexible and simple to run, but the main downsides are that the company will have to fund the cash, and there are no tax savings to be had – any cash payments would be treated like a normal cash bonus for tax purposes.
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