Competition between businesses seeking to recruit and retain employees has led to a decrease in the number of top-performing companies rewarding their key staff by salary alone. Equity incentive schemes, in particular, have become commonplace for companies looking to attract, retain and incentivise top talent.
Yet while large numbers of businesses have taken advantage of the benefits of equity incentive schemes to attract and retain high-calibre staff, incentivise them to contribute to growth and remunerate them in a tax-efficient manner, such schemes have traditionally been overlooked by family-owned businesses. This has been largely due to a widely held perception that equity incentive schemes cannot be implemented without diluting the family’s control and majority shareholder benefits. The implementation of such schemes usually also requires the wider family’s approval, which can be a difficult process for such businesses to take.
There are, however, a number of ways in which a share ownership scheme can be structured so as to protect a family’s interests while also bringing long-term benefits to the business. The key to the implementation of such a scheme lies in its design.
This article explores some of the benefits of such schemes and the key protections that any business owner, and in particular family owners, may wish to include when introducing one.
Benefits of share incentive schemes
Share schemes have clear benefits as they:
- encourage greater employee engagement, innovation, and improved business performance;
- help with the recruitment of high calibre staff;
- help to retain key staff by being directly linked to an employee’s continued service and resulting in a forfeit of value if the employee decides to leave the business; and
- often have tax benefits for both employers and employees. For example, if the shares or options over shares are acquired under a properly structured tax-advantaged scheme, participants will not pay income tax or National Insurance on the purchase of shares or on the grant or exercise of an option to buy shares. One type of share option scheme in particular, the Enterprise Management Incentive (EMI) scheme, is well suited for many family businesses as it is extremely flexible and allows options to be given and exercised free of tax, provided certain conditions are met.
Key owner protections when implementing a share incentive scheme
The following protections should be considered by owners when implementing a share incentive scheme:
- Voting rights. A company can create different classes of share to be held by employees, carrying different and reduced rights to those shares held by family members. In particular, the family owners may wish to ensure that employee shares carry limited or no voting rights, to reduce the risk of employees having any say in the governance of the company. Control would thereby remain in the family’s hands, with very defined rights given to employees.
- Income and capital. Different share classes may also be given different rights as to income and capital distributions. For example, restrictions on the right to dividend payments can be imposed so that family shareholders receive a dividend before employee shareholders, or alternatively, employee shareholders do not receive dividends at all. Similarly, in respect of capital payments, shares held by the family can be given priority over employee shares, so that employee shareholders are only paid if sufficient assets remain after the family has received its full distribution of capital.
- Vesting provisions and option arrangements. A business may also limit employees’ economic rights in respect of their shares by making those rights conditional on the occurrence of certain trigger events. A scheme could provide that shares will not vest until an employee has been with the business for a particular period or met certain performance targets, or unless the company achieves a certain enterprise value. This can help to ensure that an employee is motivated to stay with the business, perform well and contribute to its ongoing growth and success. Alternatively, rather than issuing shares to employees upfront, businesses may wish to consider granting them options over shares. These give employees the right to acquire a particular number of shares for a specified price on the occurrence of certain events or when certain targets have been met, and as such are often more attractive to any family shareholders unwilling to offer equity ownership to new employees immediately on their arrival.
- Compulsory transfer provisions. A scheme might also provide for employees to forfeit their shares on the occurrence of certain events, such as termination of their employment. This allows a company to ensure that, aside from family members, it does not have any shareholders who are not current employees. Compulsory transfer provisions like these often distinguish between “good” and “bad” leavers. “Good leavers” (such as those who retire or leave for reasons of ill health or death) may be entitled to the fair market value of their shares on leaving. “Bad leavers” (such as those who breach their employment contract, are dismissed for misconduct, or leave before an agreed date) may simply be entitled to nominal value.
- Restrictions on transfer. Businesses often wish to prevent employees from transferring their shares to anyone other than existing shareholders, to ensure that unknown third parties cannot become shareholders in the company. Share transfers may be restricted in their entirety or limited to a small group of permitted transferees (such as the employees’ family members). Transfers can also be made subject to certain conditions, such as the consent of the company’s board of directors or its majority shareholders. In addition, pre-emption provisions can be included, whereby an employee must offer their shares for sale to the company or to existing shareholders before transferring them to a third party, which again allows the family shareholders to remain in control. An alternative means of ensuring that shares remain with existing shareholders is to put in place an internal share market whereby the company sets the share price annually or bi-annually and trading windows open for specific limited periods throughout the year, during which share transfers between existing shareholders are permitted.
- Anti-dilution provisions. Issuing new shares to employees is likely to have the effect of diluting the shareholdings of existing shareholders. To mitigate this, a family business can limit the size of the pool of shares which can be granted to employees. It is common to see a cap on the employee share pool of up to 10 per cent, but lower (or higher) caps can also be used, as appropriate for the business.
- Drag along rights. Another practical consideration for a company in which employees hold shares is to ensure that employee shareholders cannot block a sale of the company which the majority shareholders wish to pursue. To address this, an employee share scheme might provide that, if a specified percentage of the majority shareholders wish to sell their shares, the employees must also sell their shares to the same buyer on the same terms and at the same price. This is known as a “drag-along” right for the majority owners. Employees can also be obliged to give the board or majority shareholders the power to effect the sale of the employees’ shares on their behalf.
Phantom share schemes
If, despite the availability of the protections set out above, there remains a reluctance to issue shares to employees or grant them options over shares, family owners may wish to consider implementing a “phantom share” arrangement, which replicates the benefits of an employee share scheme without involving any actual share issuances.
Phantom share schemes are cash bonus schemes whereby bonuses are calculated by reference to the notional gain in value on the shares. In other words, the employee does not receive any equity in the company, does not become a shareholder, and does not acquire rights as a shareholder, but does receive a cash payment in accordance with the terms of the plan and based on the increase in value of the company’s shares. With careful drafting, such a plan can reward employees in line with the company’s growth in value.
Any payments made by a company in respect of a phantom scheme will be treated as income by HMRC, meaning that income tax and National Insurance will apply. A phantom scheme will thus be less tax efficient than some share schemes, in particular the EMI. However, this may be considered an acceptable trade-off to allow the family to retain full ownership of the company.
In conclusion, many senior employees expect to participate in the value that they add to a business, and if this equity upside is not available, they may decide not to join, or to move elsewhere. Many family-owned businesses, meanwhile, feel reluctant to share ownership of their company with non-family members. With careful planning and advice, however, if there is a high quality candidate being considered, it is possible for a family-owned business to implement an employee share scheme which incentivises and rewards key staff effectively, whilst at the same time ensuring that the family’s interests are protected.
For more information on how family businesses can introduce employee ownership, see our recent article on employee ownership trusts, which can be effectively utilised as part of a family business’s succession planning.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, June 2021