Incentivising and rewarding key staff – your options

I want to incentivise and reward my key staff members within my company, but I’m not sure if I want to give away shares. How do I protect myself?

Partner Jim Truscott looks at the issues.

Being an owner-manager of a small or medium sized business can be a lonely and difficult experience. One of the most challenging aspects is to keep hold of key staff members, giving them a sense of “ownership” of the growth of the business and its decision-making, and giving them a reason to remain with you for the long haul – and perhaps until such time as you achieve a sale or retirement from the business. How can this be achieved without giving away too much?

For key management team members, a combination of salary and bonus may not be enough to keep them locked into the business. To achieve this, usually some element of share ownership or share option entitlement is the answer.

Share ownership

In some circumstances, there is no real substitute for giving a shareholding to your key people, such that they have an ownership stake in the company and participate to an agreed extent in its fortunes. Giving away equity in this way is not without risk, both legally and commercially, and needs to be considered carefully – we see many instances where majority shareholders regret having structured their allocation of shares across their shareholder base without having considered the long term ramifications of this, and in particular it is tempting in a relatively young company for its owners to issue equity fairly freely, in order to bring people on board, only to regret this decision later on.

However, there is no reason why equity ownership cannot be managed carefully in such a way as to protect the majority owner of the company. Classes of shares can be created to give particular rights to particular shareholders, in relation to voting, income (for example, dividend income) and capital return (for example, a rights to receive a proportion of a payment of capital in the event of a sale of the company).

The rules of law in relation to the structuring of equity do allow a considerable level of flexibility in relation to these matters, and it is possible in addition to structure a class of shares in such a way that it participates only in a level of profit over and above a prescribed base level – ensuring that a shareholder participates in growth of the company from the time of his or her acquiring the shares, rather than ‘inheriting’ historical value.

Equity documents are required, and should always be entered into, governing these arrangements. These generally comprise both a shareholders’ agreement and bespoke articles of association, describing the rights set out above in detail, and – in particular – generally prescribing that in the event of the shareholder ceasing to be employed by the company, his or her shares are to be transferred back to the company or to the remaining majority shareholders. If documents of this sort are structured properly, there is little or no risk of exposure for a majority shareholder of a shareholder dispute arising.

Having said this, and acknowledging that in certain circumstances there is little substitute for offering a “real” shareholding in a company, there are shortcomings in issuing shares from a process and practical perspective. Not least of these is the requirement to prepare and negotiate the equity documents described above, as these require some legal input and can be complex. There is also the practical aspect of needing to manage a shareholder’s departure from a company and take his or her shares back in the event of this departure – this should not be a problem in practice, but is an additional administrative burden on a company. For this reason, one would generally seek to go down the route of issuing share options rather than issuing shares, where this is feasible.

Share options

Put simply, the alternative to issuing shares, as described above, is to issue an individual with share options. These give a right for the individual to acquire shares in the company conditionally upon certain future events occurring. There is a high degree of flexibility available in relation to how these option rights operate in practice, but a classic scenario is that an individual is granted options giving a right to acquire shares immediately prior to an exit event, being a sale of the company (or in limited circumstances, a flotation of the company).

The commercial effect lying behind this structure is that the option holder is incentivised to remain with the company until the achievement of an exit event, and is thereby “locked in”. In the event of a sale of the company occurring, the share option becomes exercisable, and immediately prior to the third party purchaser acquiring all of the shares of the company, the option holder exercises the option to receive the shares, and sells these alongside the other shareholders to the third party buyer.

In practice, therefore, the individual in question becomes a shareholder for a notional fraction of a period, only to sell the shares immediately thereafter. However, one significant upside associated with share options of this nature is that their tax treatment is highly favourable, offering relatively low rates of tax to the individual on the amount received following the sale of the shares.

The above outline of differences between equity and share option ownership really only scratches the surface of these issues, but I hope it provides some insight into the drivers behind decision-making on this subject. We would be happy to discuss the subject with you further, and our combined corporate and employment teams work with a number of clients on these matters on an ongoing basis.

First published in North West Business Insider