We are frequently asked to advise clients on the best way to incentivise their existing and future employees. This is an important consideration for any company (and particularly start-ups) who wish to, for example, attract and retain talent. There are a variety of ways in which employees can be incentivised, and it will always be important for the company to consider what the ultimate goal is that they wish to achieve by incentivising their employees. For the purposes of this article, we will only deal with one of these incentivisation options, namely: “Issuing shares to employees”.
In terms of the Companies Act, 71 of 2008 (as amended) (“the Companies Act”), any issuance of shares must be for “adequate consideration” as determined by the company’s board of directors. For example, where the founders of a company wish to award their long-serving employees with a stake in the company, the services rendered by those employees may be considered to constitute “adequate consideration” and the shares can be issued on this basis. Another example of incentivising employees is to offer identified employees a reduced salary together with an issuance of shares in the start-up company, which shares can be issued at a nominal value and could be considered “adequate consideration” in the circumstances. Alternatively, a company can issue shares to identified employees at the fair market value of such shares but the subscription price (being the fair market value) payable for those particular shares is loaned by the company to the employees (note that such loan would qualify as financial assistance and would require specific authorisation). The loan would then be repayable from any dividends that are declared and paid by the company to those employees as shareholders of the company.
Shares may also be issued for future services to be rendered by an employee to the company, but then these services must be rendered by the employee before he/she will be entitled to receive the shares. In such cases, the shares are held in trust and then transferred to the employee upon fulfilment of their service obligations in accordance with section 40(5) of the Companies Act.
More commonly, however, we are approached by start-up companies who wish to set up employee share ownership plans (generically referred to as “ESOPs”) for the purposes of issuing shares to (key) early-stage employees. Some larger or institutional investors require that companies commit to establishing an ESOP as a condition to their investment into the company. In other cases, a company may simply want to establish an ESOP to incentivise and reward their employees of their own accord.
ESOPs can be structured in a number of different ways, for example, employees may be offered direct shareholding in the company or options for the acquisition of shares in the future. Alternatively, a phantom / notional share scheme can be set up – for more information please see our previous article, EMPLOYEE SHARE OWNERSHIP PLANS: SOME ‘WHY’S’ AND ‘HOW’S’.
Once a company has decided that it wishes to incentivise some or all of its employees by way of one of the methods mentioned above, the next important consideration will be the terms and conditions upon which the shares will vest in the employees’ hands. The concept of “vesting” in broad terms means the moment when the employee becomes the full (or beneficial and registered) owner of the shares in question. Such shares may vest over any determined period of time, and may, for example, be subject to the employee meeting certain goals or milestones or remaining with the company for a particular period of time.
Regardless of the manner in which a company may decide to issue shares to its employees, it is key that the employee’s ability to transact with such shares is restricted in some manner. One of the more common restrictions placed on shares issued to employees is that such shares cannot be sold until the occurrence of a “liquidity event” – this is an event that allows the majority of shareholders to exit by selling their investments or realizing the value of their shares. The most common examples are: (i) the sale of all or a majority of the shares in the company; (ii) a sale of the company’s primary assets or business; (iii) a merger or acquisition of the company; (iv) an initial public offer (IPO); or (v) a change of control generally or a similar transaction.
Placing restrictive conditions on shares that are issued to employees is significant for two primary reasons. Firstly, if these shares are unrestricted and can be sold by the employee at any time, this somewhat undermines the motivation for retention of employees. While this purpose could also be achieved through the vesting of shares, there is a further reason why you should consider restricting the shares. In terms of the Income Tax Act, 58 of 1962 (as amended), any “income” that is derived from the disposal of shares that have been issued by a company to its employees by virtue of their employment is taxed in the hands of those employees as income tax. However, if these shares are “restricted” (i.e. cannot be freely disposed of), any “income” earned on a disposal of those shares by the employees will only be taxed in the hands of the employees upon the lifting of the restriction (for example, a “liquidity event” as described above), and the employees will only be required to pay such income tax at the time of disposal of such shares. Any disposal of shares may also attract capital gains tax, which employees should be aware of as well. Specialist tax advice in this regard should always be sought and we will gladly refer you to one of our trusted tax specialists for this purpose.
The Start-up Team have developed a ready-to-use suite of agreements for a simple, direct-shareholding based ESOP with the aim of providing a cost-effective and efficient service as one of our value-added offerings to our clients. If you are considering ways in which to incentivise your company’s valued employees, our dedicated Start-up Team would be happy to meet with you to discuss your needs and assist you in structuring the appropriate employee incentive scheme for your company.