Skin in the Game? An Introduction to Employee Share Schemes

Recent changes to the regulation of Employee Share Schemes (ESS) of late have brought discussions about implementing an ESS to the fore for many companies.

This article summarises the ESS basics – why so many companies use them, what the two most popular structuring options are, and what kinds of interests in the company can be issued under an ESS, as well as recapping the latest updates. Of course, if there’s one takeaway from this introductory guide, it’s that there are many ways to skin the ESS cat, and boards have a lot of discretion in tailoring an ESS to suit their company’s goals.

POTENTIAL BENEFITS OF AN EMPLOYEE SHARE SCHEME

There are countless reasons for implementing an ESS, chief among them is to incentivise employees to achieve the best results for the company by giving them ‘skin in the game’. By holding shares, employees benefit from the increase in valuation of the company. This can motivate employees to achieve business-wide and macro profit goals, rather than exclusively their own KPI’s. It’s also a great way to provide remuneration for cash-strapped early-stage businesses. Employees also become eligible to participate in any dividends the company issues.

Involvement in the ESS is typically reserved for senior employees or managers, though ultimately the company has total discretion over which employees are invited to participate.

The rules of the ESS can stipulate that employees forfeit their interests under the ESS when exiting the company. This is a fairly standard requirement, which can encourage loyalty (especially when the company is paying dividends) because the employees have access to better benefits under the ESS if they stay.

Another commonly cited reason for creating an ESS is to provide an additional form of remuneration, or a different way of issuing a bonus. As with other forms of employee remuneration, under an ESS employees share in the success in the company: in the case of the ESS this is through receiving an interest in the company securities (and by participating in any dividends).

KEY FEATURES / DOCUMENTATION

Establishing an ESS that suits your company’s needs can be daunting, as there are a lot of options for how to set up and run an ESS. The set up also requires advice from professionals, especially because of the scale and type of documentation needed to operate an ESS, which includes:

• Plan rules: where anything other than an immediate share grant is offered, employees receive an ‘award’ under the ESS. The plan rules dictate what an employee can do with their award before they convert to shares in the company (or units in the trust – more on this below).
• Shareholder’s agreement: if an employee is receiving shares in the company directly, there should be a set of rules around what happens once the employee has actually been issued the shares. The plan rules usually require that the employee accedes to the shareholder’s agreement, which ‘takes over’ once an employee actually gets their shares, although the plan rules can also be used to this end.
• Resolutions: the company should carefully consider if any board and shareholder approvals and resolutions are needed to implement the ESS. What resolutions are required (if any) will vary from company to company and will be dictated by the Corporations Act and the governing documents of the company.
• Offer Letters: to grant awards under an ESS, the board must issue an offer letter to the employee. This letter generally contains details about the offer, as well as several disclaimers about the kinds of advice employees should seek before accepting the offer. If they choose to accept, employees do so by signing and returning the offer letter.
• Trust documentation: in the event a trust structure is used for the ESS (see more on this below), further documentation is required. This includes preparing a trust deed, and often a unitholders deed (to cover the rules about how employees dispose or transfer their units in the trust, though as with the shareholders agreement this can also be covered in the plan rules), and other related documentation.

TRUST VS DIRECT HOLDING STRUCTURE

There are two primary ways to structure an ESS: through a trust, or through a direct holding structure. In either structure, an employee is typically able to nominate a holding entity for its shares, such as a family trust. A brief summary of these two options is as follows:

• In a direct holding structure, the company will issue new shares each time an employee becomes entitled to company shares pursuant to the ESS. This means the employee (or their nominee) will be the direct holder of the shares.
• In a trust structure, a trust is established by the company to hold the company’s shares for the benefit of employees. The company itself will set up the trust.

Usually, one of these structures will be better suited to your business than the other, so we recommend getting further advice on which is more appropriate for your business size, resources, and needs before setting up your ESS.

TYPES OF EMPLOYEE INTEREST

There are numerous ‘instruments’ that a company can use to offer interests in the company to its employees under the ESS. How these instruments operate will be governed by the relevant plan rules , and shareholders agreement of the company or unitholders agreement (if a trust structure is used).

The most common instrument is an ‘option’ for shares. This option usually has several conditions attached to it, and once the employee satisfies the conditions they can elect to ‘exercise’ their options. If there’s a price for the shares, it’s usually paid on exercise of the option. Some other common instruments include:

• Deferred Share Awards: where a portion of an employee’s salary, or more commonly, a bonus is paid in shares.
• Performance Rights: where shares are issued once an employee meets specific performance conditions imposed by the company.
• Stock Appreciation Rights: which seek to provide consideration to employees for the difference in value of stock on the date the employee actually receives the shares from the date the offer to participate was made.

Regardless of what instrument is used, the shares that are issued under the ESS can be in the same class that ‘regular’ equity shareholders hold, or may be part of another class that has voting rights or dividend rights that differ from non-employee shareholders.

Given the cost of participating and buying shares, companies may choose to assist employees in partaking in the ESS by providing limited recourse loan agreements. These loan agreements must comply with certain requirements under the Corporations Act, but are often still appealing because they allow an employee to pay the price of the ESS interest they are acquiring using the money received from the relevant loan.

LATEST CHANGES

Recent changes to the Corporations Act have made the process of providing employees with an ESS option more accessible by reducing the regulatory burden where ESS interests are offered for no additional monetary consideration for shares. Where an employee does need to pay monetary consideration to participate in an ESS, the legislation has also set out a ‘cap’ on the total amount a company can ask an employee to contribute in any 12 month period in connection with any single given offer. Most of the other changes sought to smooth out administrative matters or resolve confusing technicalities in the existing law.

Overall, implementing an ESS can motivate employees to commit to a company and its long-term vision. The flexibility in how an ESS can be structured means it can be tailored to many different types and styles of companies and management.

If you are interested in implementing an ESS or have any further questions, please do not hesitate to contact our team at enquiry@hazelbrooklegal.com.

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