Having been advising businesses on implementing effective (and fixing ineffective) employee share incentives for over 15 years, I have seen how to do it well, and how it hasn’t been done well. Given for most business owners their business is their key asset, giving away part of it is likely to be one of the most important decisions they make. Getting it wrong now could damage your business irreparably, but getting it right could be the key to aligning talent and driving the future performance of the business, potentially to a successful exit.
The following is a summary of some of the key areas to consider, and pitfalls to look out for, when designing and implementing any potential employee share incentive in your business.
What is the purpose of your scheme?
Understanding whose behaviour you want to influence, and in what way, is key to understanding the purpose of any employee equity incentive scheme. A scheme that drives the wrong behaviours in the wrong people can be more harmful than having no scheme at all.
Employee equity incentives have multiple purposes but typically include recruitment, retention, motivation, reward for historic commitment, strategic alignment, exit planning, replacing an old ineffective arrangement etc. Often the overarching aim is simply to get recipients to think more like a business owner, with a focus on long-term growth and success of the business rather than short-term remuneration and reward. Specific targets can then be layered on top of this overarching aim, to allow for more bespoke solutions for individuals or smaller sub-groups.
Sometimes schemes are targeted at specific individuals, or small groups, or sometimes they can be much more widely drawn.
My advice to clients is often to start by envisaging their future business (say in five years’ time, or at the point a suitable exit would be feasible), define the financials it will need to deliver, sketch out the management team it will need to achieve that, and then identify who of that management team will need equity incentives, and broadly how much each. This will form the skeleton of what your scheme will need to look like, and you can then start to fill in the gaps.
Getting the scheme structure right
The first question is whether you want a share scheme, or a share option scheme? A share scheme (eg growth share, flowering share) allows employees to hold real shares. A share option scheme (eg EMI) gives employees a legal promise over shares, subject to meeting certain conditions. What’s right for you is influenced by a variety of factors but many businesses choose share options due to their flexibility and favourable tax treatment. Some businesses choose a mixture of both, and even overlay a separate cash-based long-term incentive scheme as well.
If you choose share options as your primary incentive mechanism, the next choice is whether you follow the well-trodden path of an HMRC ‘approved’ scheme, or whether you go completely bespoke. Many choose the approved scheme route. Having chosen this, you then need to determine which specific scheme is right for you. Many privately-owned businesses opt for an Enterprise Management Incentive (EMI) scheme which offers tax benefits for both the recipient and the business, and is widely known in the sector. Approved schemes like EMI do however have strict rules and stepping outside of these rules (either by the business or the recipient) can have a significant cost and administrative impact, so care is needed.
It is important to note however that an EMI scheme is not an ‘off the shelf’ solution. EMI is merely a government approved ‘tax wrapper’ which wraps around a carefully designed share option scheme, giving it favourable tax treatment. EMI is itself not a product or a defined solution and no two EMI schemes are ever the same.
Also, you will need to consider whether the scheme is to be purely exit driven, or do you want to create real minority shareholders along the way. Many business owners are looking to maximise the value of their business for an exit, hence many schemes only crystallise on a sale event or similar, however using options to create real minority shareholders before an exit may be appropriate in certain situations.
A key decision in the design phase is whether the incentives are fixed percentage units in the business, or rights to participate in a fixed percentage pool. Both choices have pros and cons. With the former, the ‘currency’ is finite (either that, or the original founder becomes increasingly diluted with every new issue of incentives). With the latter, the founder only ever dilutes to a theoretical minimum level and all participants share in a designated ‘pool’ based on both performance relativities and tenure. A growing business needs a growing management team, so be careful not to give away too much ‘currency’ too early and be unable to recruit or reward the next batch of future management.
Performance conditions are key and require a lot of thought. These may be quantitative (eg Sales-based) or qualitative (eg demonstrating the core values of the business), but they need to be tailored to each individual and group to ensure they are realistic and achievable, and aligned with the wider business plan. Many schemes require all participants to be rewarded from one central pool so breaking down internal team or brand barriers, and adopting a ‘one firm’ approach, is usually key, but often challenging – but this may indeed be one of the core purposes of your scheme in the first place.
If you have (or expect to have) any international aspect to your business this needs to be designed in ahead of time. Employee share incentives are taxed differently all around the world and you wouldn’t want to send your best employee off to set up your New York office only for them to find out the net (after tax) value of their equity incentive has reduced by 40% due to them now being a US resident!
Equity incentive schemes are rarely cast in stone at the outset and, like the business, need to grow and evolve as the business does. A scheme designed only for the business as it is today is unlikely to be right for the business in three years’ time. Whether it be number of employees, size of management team, performance criteria or geography, as far as possible schemes need to be ‘future proofed’ and be able to accommodate the growth of the business they are intending to drive.
Ultimately, increased flexibility means increased cost (to set up, and to run) and increased complexity and risk (for the recipients, the founder and any future buyer of the business). In my experience, simplicity is at the heart of a successful scheme.
The key to successful implementation is good project management. If you are good at running projects internally, and have a natural appetite for and interest in complex tax and legal matters, running it yourself may be possible. However, given this is probably the biggest change in your business since inception, getting proper professional advice is recommended. A good scheme needs four key members of the project team – the founder(s), the FD, the accountant and the lawyer. Nominating one of these as the project manager is advisable. For my clients I often take on this role, but I see it like a project manager on a house build – pay someone with experience to do it properly, or try to give it a go yourself if you think you can! My advice would always be the former however.
The implementation phase will involve lots of meetings and information demands from the business, but investing the time and energy to get it right now is key. Running through with the lawyers all of the “what if” questions, and modelling all of the performance criteria permutations with the accountants, will be the best time you’ve ever invested in the future direction and ownership of your business.
The key to the success of any scheme is how it is communicated to those who join it, and equally to those who don’t. Internal briefings and Q&A sessions for potential participants, running alongside the implementation phase, are recommended. Having your advisers present at the ‘signing ceremony’ is also useful in case of any final questions or worries. Also, maintaining ongoing dialogue with recipients about how the business is performing, hence how the scheme is unfolding, is essential. A good way to do this is at periodic team/management briefings and, particularly for exit driven schemes, being completely transparent on the developing plans and timetables for the eventual exit.
For those who don’t receive anything from the scheme, but could in the future, messaging needs to be clear as to when and how they might achieve it, to ensure it remains suitably aspirational but also achievable. Ultimately, a badly communicated employee equity incentive can be worse than no incentive at all!
Many equity incentive schemes have strict HMRC compliance requirements during the implementation, immediately after it, and often annually thereafter. Missing deadlines can undo all of the hard work and planning, so having somebody looking out for this throughout is essential. Make sure you know whose responsibility it is to do all of this and ultimately ensure it doesn’t fall between stools.
Whilst an employee equity incentive scheme can be undone and replaced, it is very costly, difficult and time consuming to do so. Getting it right first time is essential and key to achieving that is designing it properly and having a team of experienced advisers around you to help steer you through the process.
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Richard Collis, Director