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Is ESOP right for your company?

An Employee Share Scheme, can be a fantastic way to attract, engage and incentivise key employees by offering stock options rather than layering on cash incentives or higher salaries.

We recently sat down with Luke Smith, CEO Orchestra, to get the lowdown on the different types of Employee Share Schemes (ESS) available for companies to use as a tool to attract and motivate their staff and shed some light on one particular scheme - Employee Share Options Plan (ESOP) - that is becoming quite popular in New Zealand.

In addition to the potential wealth impact for employees, any company wanting to create an ownership mentality and a greater sense of employee engagement can benefit from establishing an ESOP, no matter the age or stage. We've all heard success stories of employees doing very well for themselves by acquiring stock options in early-stage companies, but how common is this in NZ, and why are we seeing more and more companies take advantage of this new wave of employee ownership? ESOPs are typically most common in startups and tech companies, but can be utilised across any sector including larger and more established companies.

Firstly, what is ESOP?

An ESOP is one type of scheme, which offers share ‘options’ to employees. Once these options vest (are made available), either at performance-based or time-based milestones or a combination of both, the employee can choose to exercise their option (buy the shares) at a pre-agreed price (the exercise price). In short, employees are given the right to buy (‘exercise’) the company’s shares in the future, at a predetermined price. The rules and conditions for an ESOP offer will be set out in the Offer Letter, or Plan Rules. If options don’t vest for any reason, they lapse and can be recycled into the option pool to be allocated to other staff.

The option-based nature of ESOPs means that they can provide an appealing way to offer competitive remuneration without immediately drawing cash from the business or payment from the employee. As such, ESOPs can be an ideal option for startups and private companies in the growth stage.

Benefits for employees

  • Returns - ESOPs give employees the opportunity (or ‘option’) to invest in a business and potentially make impressive returns, usually without having to find the means to pay a large lump sum payment upfront. You’re giving employees the opportunity to share in the potential financial success of the company that they contribute towards, with no upfront barrier to participate.

  • A sense of ownership

  • Employees with an ownership stake report increased job satisfaction and motivation.

One survey that’s been tracking 5,504 workers since 1997 shows that those working at companies with employee ownership have had consistently better jobs and benefits and higher wages and wealth, regardless of the industry they work in.

What’s in it for employers?

When employees can acquire an ownership stake in the company at a locked-in, often attractive price, it creates a powerful bond between a business and its employees. Benefits include:

  • Optimising employee retention - A survey conducted by the Employee Ownership Foundation found that 67% of employee-owned companies reported increased employee productivity, and 63% reported higher employee retention rates (2018).

  • Improving workplace culture & job satisfaction through a sense of belonging - “Companies with share ownership in their pay package are associated with high-trust supervision, participation in decisions, and information sharing, and with a variety of positive perceptions of company culture.” (Blasi, Freeman, & Kruse, 2006).

  • Boosting productivity & profitability - SME's with a share scheme had a 94% growth rate in sales and a 56% growth rate in value add per employee over a three year period, compared to 62% and 29% respectively for SME's without an ESOP (ABS, 2015).

  • Increasing customer loyalty through improved service.

  • Can be used as part of a potential exit or sale strategy for current owners to eventually pass ownership to staff members.

Given organisations with the most engaged employees experience higher productivity, higher customer engagement, better retention and 21% higher profitability, the benefits of ESOPs can soon outweigh the costs of implementing and managing such a scheme.

Are all employee share schemes created equal?

There are different types of Employee Share Schemes that will suit different businesses. The main options include:

1. Employee Share Option Plans (ESOP)

An ESOP is a method of granting equity (or ownership) to an employee over a period of time. The employee initially receives options to purchase shares at a later stage, but they are not obliged to purchase them. ESOPs are often favoured by early-stage growth companies, where the company doesn’t have the cashflow to pay large salaries, employees may not be able to afford to purchase shares, and/or the future of the company is still hard to predict.

Share options are traditionally earned through longevity in the company and/or performance milestones. Share options will normally defer the tax payable by the employee until the point the options convert to shares. Eventual tax implications for the employee can be aligned with the employee’s opportunity to sell the shares when it will be easier to find any tax payment.

Early-stage investors will often request that an ESOP is implemented prior to their investment, as they recognise their potential value for the company. More mature companies can also benefit from ESOPs when they are heading toward a sale or liquidity event.

2. Employee Share Trusts (or loan-to-purchase)

Employee Share Trusts will typically be used to immediately ‘sell’ ownership of shares to employees. Often favoured by more established companies, a Trust entity can be established to hold shares for employees in the parent company.

Typically businesses will either offer a low or no-interest loan (or a bonus payment) to employees to fund the purchase of the shares. The pay-down of the employee loan would usually be from any profit share entitlements (dividends) from owning shares. However, sometimes loans will not require repayment until such time as an eventual liquidity event in the company when the employees realise their gain from owning the shares.

3. Phantom or Bonus Share Schemes

“Phantom” share schemes create some of the benefits of formal share ownership without requiring the physical transfer of shares or options. Often favoured in businesses with a strong profit share focus, Phantom schemes allocate ‘shares’ to employees who will get a cash bonus based on their ‘ownership’ when dividends are calculated and/or a liquidity event occurs.

Where do you start?

The first thing to do is decide which method of employee share scheme is right for your business. We’d encourage you to talk to your professional advisors such as lawyers or accountants first to ensure you choose the best scheme to achieve the outcome you’re after and to be aware of the various tax implications.

Once you’ve decided on an approach, the ESOP pool is allocated. This typically sits around 5-15% of total shares in the company. Employees then negotiate their ESOP and can use a tool like Orchestra to manage and oversee their progress towards their ownership.

Employee Share Schemes can be complicated and difficult to maintain. Orchestra helps to maintain ESS with ease, and gives employees full transparency of its benefits over time. Learn more about Orchestra's ESS module.

If you are interested in learning more about Employee Share Schemes get in touch.

Written by Ariane Tredrea
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