Share schemes are great incentives to attract and retain employees but what can startups or thinly traded listed stocks offer when performance rights are not suitable?
Designing an appropriate Employee Share Scheme (ESS) for a private company involves a very different set of challenges compared to a publicly-listed entity.
ESS can be a great incentive for employees but the biggest challenge for private companies is dealing with the liquidity crunch which arises as employees meet their tax obligations.
As a broad rule, employees that receive shares or options will be taxed on the value of their asset — but in the case of private companies there is no public market and the asset cannot easily be sold, which makes it much harder to value.
Listed companies do not have this same issue, as the market value is clear and employees can simply sell the shares they receive to fund the tax liability. As a result of this, listed companies often utilise performance rights or restricted stock units (RSUs).
Both performance rights and RSUs involve granting employees options to acquire shares that are exercised after a period of time (often referred to as a vesting period) or on the satisfaction of certain performance criteria, with no payment required.
When the options vest, it will trigger a tax liability for the employee. However, where the employer is a listed company, the employee will generally choose to sell some or all of the shares to pay the impending tax bill.
Selling shares for heavily traded, blue-chip companies will hardly raise an eyebrow and will not affect the market, but what about listed stocks that are thinly traded?
We have seen cases where selling sufficient shares for a thinly traded stock can create up to a 30% discount on sale, which erodes much of the value received by the employee and depresses the share price at the same time.
Furthermore, performance rights generally involve the granting of significant amounts of equity to senior management, and it is not the best look when investors see senior management selling shares, especially given in certain circumstances this needs to be disclosed to the market.
For thinly traded listed or private companies, a less common but equally effective option to consider is a company-backed loan scheme. Instead of offering employees an option to acquire shares, the company offers an employee a limited recourse interest-free loan to buy the shares.
The limited recourse feature of the loan means that the employee is protected from downside risk if the value of the shares falls below the outstanding loan balance.
From an economic perspective, this perfectly mirrors an option plan with a current market exercise price as employees have no downside risk, and upside gains where the share price or value increases from current levels.
As the shares are purchased at market value, ESS rules do not apply and the employee is not assessed for tax on receipt. Instead, the employee’s shares are subject to capital gains tax treatment, meaning they will likely receive a concessional 50% tax on selling the shares where they are held for 12 months or more.
In addition, employees can benefit from share ownership from day one, and in particular, access dividends declared by the company. It is important to note that ordinarily, dividends are partially redirected to pay down the loan and only sufficient cash to pay tax on the dividend is released to the employee.
While the scheme can deliver good outcomes for participants, loan-backed schemes can also be more complex to set up than performance rights, and potentially more costly, while there are other tax and commercial law issues to consider.
In particular, vesting can be more challenging to handle than performance rights, although there are always solutions available to achieve the desired commercial outcome.
To this end, Pitcher Partners has agitated for further legislative and administrative changes that could lead to the simplification of the income tax treatment of ESSs in Australia.
For small percentage shareholders, such as employees, we have called for loan-funded schemes to be carved out from Division 7A, the tax provision that covers loans from private companies.
Another downside is that ESS interests acquired under loan-backed schemes generally cannot be alienated or transferred to associates of the employees, such as family trusts, without fringe benefit tax implications.
But even in the current environment, loan-funded plans can yield good results for suitable companies and may present an economically identical alternative to rights-based schemes.
Performance rights are the most popular structure for ESS but they are by no means the only option available, and employers should examine all options available to them before deciding.