In the past few months, we have seen a noticeable increase in the number of clients making enquiries about Employee Share Ownership Schemes/Plans (we will ‘affectionately’ refer to them as “ESOPs” for the purpose of this article). Setting up an ESOP is almost invariably a fairly expensive and time-consuming process, so we recommend that any company looking to set up such an employee incentive plan should carefully consider some of the ‘why’s’ and ‘how’s’ from the outset to ensure that the end result is firmly based on the initial aims and intentions, and that all parties understand the benefits and pitfalls. On the positive side, it is encouraging see so many companies (particularly start-ups) considering and making enquiries about their ESOP options at such an early stage, demonstrating a healthy acknowledgment of the importance of employees to business success, and a curiosity to explore a variety of corporate structuring options.
THE ‘WHYS’ AND ‘HOWS’
In an effort to bring some structure to the questions of why, whether and how to set up an employee incentive plan of some kind in a South African company law environment, we recommend being guided by the below initial considerations:
Why an ESOP?
All too often companies lose sight of the ‘why’ at some point on the road to taking a corporate structuring step. The reasons and intentions behind your ESOP should guide and inform most aspects of the way in which it is structured and implemented – if this is done, a more coherent plan results from the process. By way of a few examples:
- If your intention is to attract top talent, then ensuring that there are real ownership benefits and that the tax consequences have been carefully considered, may be more likely to attract these individuals to your business.
- If your intention is to retain top talent, consider whether the vesting or restriction provisions in your ESOP should be structured such that your employees see more benefit the longer they stay.
- If your intention is to benefit your BEE status by setting up an ESOP, consult with your rating agency as a first step in determining the best way to structure your ESOP.
- If your intention is to provide your employees with a real ‘cash-in-hand’ benefit, make sure that the ESOP benefit they receive is one which is capable of giving regular cash benefits (such as dividends).
- If your intention is to benefit every level of employee in your business, ensure that your ESOP is not overly complex, is well communicated, and does not force employees to pay for the benefit (bearing in mind that employees who live on a month-to-month basis most likely won’t want to ‘buy’ something with only a possible future cash realisation).
Finally, once you have identified the intention/s behind your ESOP, it is important to consider whether these intentions can be better served in another way, for example, through a company bonus pool or issuing options to acquire shares directly to certain employees without having these form part of an ESOP. You do not want to look back on the cost and effort in setting up your ESOP as being ultimately avoidable in favour of an alternative employee benefit structure.
What ESOP structure is best for you?
We are most commonly approached with requests for two different types of employee incentive plans, namely an ESOP which grants employees of a company the right to acquire actual shares in such company (either directly or through ‘options’), and, a phantom/notional share scheme administered by a trust (with the trust holding shares in the company concerned, and with the employees as beneficiaries of the trust, receiving benefits attaching to such shares).
The best structure for your ESOP should first and foremost be guided by its intentions, however there are some broad-sweeping generalisations which we sometimes apply in advising our clients on the best structure for their incentive scheme:
- Phantom/Notional Share Plan/Scheme: These have a great capacity for flexibility and can be geared towards giving your employees a ‘cash’ benefit without the employees having any control over shares or company decision-making, or ownership of the actual shares. These schemes are most appropriate for dividend-declaring companies with a large number of possible ESOP beneficiaries, with no need to have any ‘real’ ownership of shares in these companies.
- Employee Share Ownership Plan/Scheme: These are most appropriate for smaller beneficiary pools, where a company’s aim is to provide employees with the opportunity to acquire an actual share in the company. These do create the potential for a large number of shareholders (having the downside of creating a ‘rats and mice’ share register and attracting some administrative hassle in approving shareholder resolutions), however there are also a few structuring choices that can be made to minimise the downsides (for example by having a separate ESOP share class).
Nothing is certain but death and taxes?
It’s best to accept early on that granting your employees an ESOP benefit is bound to have a tax repercussion. We recommend arming yourself with the best tax advice in relation to the income tax and capital gains tax that might be payable on ESOP benefits, to ensure that your employees obtain the best possible benefit from their ESOP participation (bearing in mind the intentions of the ESOP), and to ensure that your company does not fall foul of tax laws by (for example) failing to withhold and pay PAYE when it becomes due.
How will you implement?
Implementation is an oft-overlooked factor of an ESOP. By way of a few examples, you might need to consider:
- The terms of your ESOP in relation to vesting and restrictions.
- The provisions of section 97 of the Companies Act, 71 of 2008 in relation to a compliance officer for the ESOP (so that the scheme does not fall within the meaning of a public offer of securities).
- Whether or not your employees will need to be bound by the provisions of an existing shareholders’ agreement for the company once they acquire shares in that company.
- If you will be running your employee incentive scheme through a trust, what are the costs and implications of registering and administering that trust.
- How will employees be allowed to exercise options to acquire shares?
- How will you communicate the ESOP benefit appropriately to your employees – not creating unrealistic expectations, but being sure to communicate honestly and effectively and providing training where necessary.
While we don’t wish to oversimplify the process of setting up and implementing an ESOP, we believe that a basic understanding of the above will be a good foundation from which to proceed. We would also recommend, as some final points, that you avoid complexity wherever possible, be guided by your intentions at all times, and don’t be afraid to ask your legal or tax advisor what might seem like stupid questions – the better understanding you have of your own ESOP, the more likely it is to be an effective business and corporate structuring tool.