The employee shareholder

A look at some of the benefits, as well as some of the associated practical considerations, for businesses which are considering bringing employees…

In this article we look at some of the benefits, as well as some of the associated practical considerations, that need to be borne in mind for businesses which are considering bringing employees into share ownership.

The rationale

Attracting, rewarding and motivating staff is a key factor for all types of organisation and employee share schemes represent an increasingly common and significant part of a company’s overall remuneration strategy.

Well-designed equity incentive or share option arrangements can be an important factor in attracting and retaining key personnel as well as helping to motivate staff by aligning the interests of employees with those of the shareholders of the company. They can also be used as part of a business succession planning strategy.

Encouraging wider employee ownership is something the government has been, and continues to be, keen to support and there have been a range of regulatory and legislative initiatives in recent years, some more successful than others.

Environmental and economic factors, such as the move from a manufacturing to service economy where the value of many businesses is in the human capital, have also contributed to the upsurge in employee share ownership.

There have also been a number of reports and surveys that have found that a positive correlation between firms that have brought employees into the ownership and improved performance and customer service.

Design and implementation

The key to any successful employee share scheme, which can encompass a wide range of potential alternatives from option schemes based around an exit or succession to simply issuing shares to employees, lie in the careful design and implementation of the arrangements in order to deliver the requisite benefits as well as the effective communication of the benefits to the relevant staff.

How the proposals are communicated is often as important, if not more important, than the actual proposals themselves. In order to deliver the desired benefits for all parties, both the current shareholders and the employees to whom shares (or share options) are to be offered must appreciate the potential rewards and benefit of share ownership and “buy in” to the proposal.

The first step is therefore to determine whether becoming co-owners is something that the employees actually want. This point is one that is sometimes overlooked. There is no point offering staff a share in the business if they believe it is simply a token gesture that will not actually deliver any tangible benefit or reward.

Whilst there can be a psychological benefit in granting employees shares or share options, making them feel valued, in most private companies where there is no market in the shares the only real economic return is likely to arise on a sale (or listing) of the company.

By way of example, if a family business grants employees share options that can only be exercised on a sale of the business and there is no underlying plan or objective to grow and sell the business on the basis it will be passed on to other family members such as the children of the owner, then an ’exit only’ share option scheme is unlikely to actually incentivise or motivate staff. In these circumstances, providing staff with shares on which annual dividends can be declared (on a potentially more tax efficient basis than say the payment of bonuses) would perhaps be more attractive and relevant to the staff.

As indicated above, share ownership does allow for employees to be able to receive dividends and share in profits but the ability to receive such dividends are dependent upon the company’s reserves and business needs and therefore will usually remain at the discretion of the owner(s). Care is therefore required not to over emphasise this benefit if, in practice, dividends are likely to be infrequent or of very modest sums as this could undermine the whole purpose of the arrangements.

Alternatively, an annual cash bonus scheme may be more attractive to the employees and may offer a degree of lock in, though not perhaps as much the issue of shares or share options would. Unlike dividends, bonus payments and other cash incentives do not have to be matched by available distributable profits but still have to be funded which is another attraction, all things being equal, of the use of share incentives.

Issuing shares vs options

A key question is whether employees are to be:

  1. Actually issued shares or have shares transferred to them; or
  2. Granted options which give them a right to acquire a certain number of shares (at a pre agreed price) at a certain point in time or upon certain events (such as sale or change in control of the company).

Options can strike a balance between concerns that the current owners and shareholders have about having additional shareholders and the attendant practical issues that entails whilst also providing the employees with a ’one way bet’ in that they will only exercise the option if it is in the money i.e. where the shares have grown in value so that the price they have to pay for the shares is less than their worth. As noted above, unless the shares under option carry dividend rights and there is an actual intention or commitment to pay regular dividends, many share options are only exercised immediately prior to an exit (sale or listing) of the company so that the employees exercise their options and immediately sell their shares.

Options can also help to retain employees and lock them into the business in the sense that the terms of the options can provide that they lapse (in whole or in part) if they leave the business. They therefore only receive any value from the options if they remain with the business.

Issuing shares as opposed to granting options can, with some careful planning, achieve the same objectives. There will, for example, usually be a provision for the company / other shareholders to take back the shares from employees who leave (see further below).

The potential advantages of issuing shares upfront as opposed to options are that it can help employees feel more valued and part of the business and allows for them, as shareholders, to participate in any dividends.

Dilution and voting rights

Whether issuing shares or options, another important question is how much of the equity you are willing to set aside for employees.

This needs to be considered not just in terms of economic value but also in terms of influence and control (through the voting rights attaching to the shares).

The two do not have to necessarily correlate and a separate class or classes of shares can be created where the economic and voting rights can be fixed or vary depending upon the circumstances. It is, for example, still quite common for employees to be given shares with no voting rights where the owners do not want to relinquish any control (but as noted above the rationale for this and the other economic benefits of share ownership will need to be clearly set out).

On the other hand, if granting exit only options, then the issues around voting rights are largely irrelevant as the holders of options do not have any voting rights as they will not become shareholders until immediately prior to their sale.

Issuing shares or options dilutes the existing shareholders (albeit in the case of options only when the options are exercised). It is possible to ensure that the dilution is only borne by one shareholder (or group of shareholders) and not the others but, in any event, most companies will look to limit the number of shares or options that are granted to employee. This maximum dilution limit can, if necessary, be built into the terms of the relevant employee share scheme. A maximum dilution of between 10% - 20% is common.

Another factor that needs to be considered in this respect is that in order for employees to be able to qualify for Entrepreneurs’ Relief on a later disposal of their shares then, unless they acquire their shares via an Enterprise Management Incentive (EMI) share option scheme, they need to hold shares that carry an entitlement to 5% or more of the voting rights.

What protections and benefits might the business expect in return?

Evidence supports the view that businesses which have brought key employees into equity see profitability improve and, in addition, the owner may hope to see greater long term stability as the longer term impact of share ownership takes hold. But are there other benefits that might accrue for owners, or protections that they might seek, when issuing shares or share options to staff?

Revised employment contact terms?

There is no reason in principle why the offer of shares or share options should not be linked in hand with the quid pro quo requirement for the employee to enter into revised employment contract terms. So if, for example, an employee has been on fairly basic (or even non existent) formal written terms, now may be the time that he or she is asked to step up to the plate and, as a shareholder, be expected to commit to a more rigorous employment contact.

It may be that the length of notice the employee has to give to the company should be extended and/or any restrictive covenants revisited or added if none were previously included. If the employee is responsible for the development of any intellectual property rights, does the agreement make it clear that the company owns them?

Obviously this should not be overdone otherwise there is a risk that the positive impact of granting the share or share options may be diminished. It is, however, certainly an area that bears thinking about.

Shareholders' agreement?

Whenever widening the shareholder base to include employees it will need to be considered whether a shareholder agreement is required – see our previous article on shareholders' agreements for more details.

Whether or not a separate shareholder agreement is required, the articles of association will need to be reviewed to ensure that they incorporate appropriate provisions to reflect the relevant proposals, particularly when first opening up the shareholder base and offering shares or options to employees.

A brief consideration of a few of the practical issues and key provisions to consider in relation to a shareholders’ agreement or the company’s articles is set out below.

Transfer restrictions

In bringing employees into the share ownership, it will generally be a concern of the existing owners to ensure that they are still able to keep control of who can acquire shares and become shareholders. Whilst there is not usually any market in the shares of private companies it will nevertheless be important to ensure that employees cannot sell or transfer their shares to any other 3rd party. As such, the articles will need to include appropriate restrictions on the ability of the employees to transfer their shares. This is normally dealt with by either making the employee shares non-transferrable or only transferrable with the consent of the board or majority shareholder(s). Alternatively, or in addition to this, the articles can set out pre-emption provisions whereby if shares are proposed to be transferred or sold, they have to be offered to the existing shareholders first.

Leavers

In bringing employees into the share ownership, it is essential that due and proper consideration is given to what happens to the shares or options if the employee leaves prior to any exit event.

Employees may be allowed to retain all or part of their shares but if so they will remain shareholders with all attendant rights as such (right to receive copies of the accounts and to receive notice of and attend shareholder meetings etc).

This is not usually desirable and therefore in the majority of cases, provisions will be added to the articles of association of the company (if not included already) to require any employees who leave to offer their shares for sale to the company, existing shareholders or both. These are known as compulsory transfer provisions.

Good leavers vs bad leavers

The articles will also often provide for the price at which the shares are to be offered for sale to differ depending upon the circumstances of their departure. These are colloquially known as ’good leaver/ bad leaver’ provisions. Typically, unless the employee is a good leaver (which will usually be defined to include where they cease employment as a result of death or illness, injury or disability and could also include retirement, redundancy), they will be a bad leaver.

Where a leaver is a bad leaver, the sale price of their shares will often be defined as being the lower of the issue price or nominal value of the shares and the current market value of the shares.

If a leaver is a good leaver, the price they will receive will tend to be the current market value of the shares.

Where employees are granted options and the terms of the options are such that they may be allowed to retain or exercise the options after they cease to be employees, it is important to ensure that, where appropriate, any compulsory transfer provisions apply to any shares acquired after they have left employment.

Drag along

Another practical consideration where employees hold shares or options is to ensure that if the current shareholders (or relevant majority) want to sell the company they can ensure that the employee shareholders cannot block the sale and are therefore required to sell their shares to any purchaser. These provisions, which are known as ’drag along’ rights, will need to be incorporated in the articles and can also be included in the terms of any share options (i.e. the terms of the options can provide that if exercised on or prior to a sale of the company the option holders can only exercise if they agree to sell their shares to the purchaser).

Succession planning

We have looked at some of the practical implications and considerations of having employee shareholders but another reason for granting employees shares or options is to bring on the next generation of management who may, in turn, provide an exit route for the current owner(s) via a management buy out.

In this scenario, arrangements can be put in place for the management team / next generation to build up their equity stake in the business with a view to the existing owner(s) retiring and selling their shares to the management team. If the management team have an existing equity stake in the business (which can be built up over time), this may make it easier for them to raise the capital required to fund the buy out of the existing owner(s).

A management buy out is often structured by the management setting up a new company that acquires the shares in the existing company with the owners receiving cash or loan notes on the sale of their shares (which can be paid out over time) and the employee shareholders rolling over their shares i.e. swapping their shares in the company for shares in the new company.

Continuing this theme, in the next article in the series, we will look at preparing your company for sale.

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