Mark Womersly looks at trends in employee incentive schemes.
An agency’s "culture" remains a critical point remains a critical point of differentiation in a complex and competitive market place, while commitment is still seen to be a key attribute of senior executives. With a number of high-profile "exits" in the recent past reminding the marketing services industry of the opportunity that still exists for capital creation, Mark Womersley, head of Osborne Clarke's employee benefits practice, examines some recent trends in the area of share related employee incentive arrangements.
Stakeholding – where are we now?
The notion of a stakeholder culture seems to have crept up on us almost unawares, but it is now a recognised and accepted term. What it actually entails is hard to pin down, but in broad terms it expresses the creation of a business environment which provides for a commonality of interests between employers and employees. The emphasis is on the mutual benefit of all involved and those that promote it tend to do so on the somewhat suspect basis that it is a "win/win" idea.
That said, despite new proposals in the recent Budget, to date there has been as much rhetoric about stakeholding as specific policy initiative, and it may be this vagueness that has led traditional protagonists at either end of the employment spectrum (for example, the CBI representing employers and the TUC representing workers, together with their traditional political allies) to embrace the idea with equal enthusiasm.
The marketing services sector
Self-evidently, businesses in the marketing sector, particularly the more mercurial and independent ones, rely almost exclusively on the skills and loyalty of a few key individuals who work for them. Accordingly, these developments in "stakeholding" present significant opportunities, but there are also risks to be managed.
Recent trends suggest that the key employees of such business now want to have that sense of ownership which was once exclusively the domain of a handful of entrepreneurs who characteristically had their names over the door. Unfortunately, employees tend to perceive the ownership of shares as a relatively simple exercise, while the reality is rather more complicated. Unlike the typical partnership, acquiring equity in a business through the purchase of shares will usually mean attributing a value to the goodwill of the business itself. Employees taking shares will be looking for a capital return for investing in that goodwill, as well as receiving the normal mixture of salary, bonus and other benefits. Getting the right balance in the overall incentive package (including any prospective capital gain) can be very difficult.
However, founder shareholders of a business may well hold their shares under relatively simple arrangements. The amount of thought put into the corporate structure at the outset is often modest – far more effort having been expended on growing the business in the first place. The introduction of employee shareholders will usually require all this to change, not least because the company will have achieved significant commercial success by this stage and therefore have real capital value.
For example, the provisions in the articles of association dealing with share transfer rights often need fundamental review. Also, issues about share valuation will become much more pressing as employee shareholders seek to attach a value to their investment. In practice, this means there will need to be some careful development of the principles underlying the articles of association and any associated shareholder agreement.
These challenges can be viewed as a diversion from the real job of growing the business. However, for the most ambitious marketing services companies it may be that achieving sustained growth will rely upon first tackling the challenge of employee aspirations for share ownership.
Handcuff or incentive?
Most debates about widening employee share ownership start with the assumption that the main aim should be to give employees incentives to grow the business. However, an additional and often understated aim is employee retention – the golden handcuffs idea. Where the skills of the key employees are at a premium, which is certainly true of the marketing services sector, these twin aims must go hand in hand.
As every business owner will know, a key employee who has the ability to attract new business, as well as developing existing business, often has a value far beyond the cost which can be attributed to salary and other direct overheads. The key employee with this type of profile will be well aware of the situation, and will routinely move job in order to enhance the overall remuneration package.
It is in this context that the offer of a shareholder stake can provide the key difference. An already well remunerated employee will then be tied into the business, and will be far more reluctant to move on if the cost is surrendering the capital gain latent in his shareholding.
For employees at a lower level the issue of retention may not be so significant. They will always be vulnerable to the job offer down the street. But what is interesting is that, even where quite modest shareholdings are acquired by less senior employees, the indications are that this can still be a highly prized asset in their hands. The "hearts and minds" aspect of this process should not be underestimated.
The problems with shares
However, shares are not without their problems. In particular:
They will only act as an effective binding agent if they are seen to have value, while for many independent companies the value of their shares may be both volatile and uncertain.
Such volatility and uncertainty can result in adverse tax consequences for the employee shareholder (and, potentially, the company).
Issuing shares to employees enmeshes the company and its board of directors in numerous administrative and legal obligations that may be difficult to combine with the business ethos and culture.
Unless the employee pays for the shares then, in effect, the incentive is a one way bet: if the "gifted" shares prove to be valueless due to trading difficulties then the employee can just walk away from the problem by taking another job rather than staying to protect his or her investment.
There is the nagging question as to how and when an employee will be able to realise value for his or her share-stake, which may in turn raise false expectations that the company is driving forward towards an "exit".
The mingling of equity and employee related benefits can be problematical: how do you distinguish between dividends and bonuses and how do you deal with employees who "go off the boil"?
As a result, independent marketing service companies are increasingly using a range of techniques to incentivise and retain key executives, including:
long-term cash incentive schemes some of which (so called "phantom share schemes") seek to replicate the benefits of shares without, in fact, the employee being issued real shares;
option schemes in various shapes and forms including schemes that have Inland Revenue approval (and therefore have certain tax benefits), "exit-only" schemes or schemes that are contingent upon certain conditions being met (including the lapse of time and financial targets); and
employee trusts which come in a variety of shapes and sizes.
Phantom share schemes and L-TIP’s
A phantom share scheme, will give the employee a return in terms of cash, rather like a conventional bonus, but the amount of the bonus will be limited to the value/performance of the company and it will be presented as being similar to an equity stake.
Typically, the amount of the return will be linked to movements in share values or dividend yield. To achieve this the scheme will entail the issue of notional shares to participants, with all the external trappings of share ownership (such as a participation certificate). For the employee who is not yet ready (or suitable) for full equity participation, a phantom share arrangement can be very attractive. For the existing shareholders the benefit is that this type of scheme will not interfere with shareholder rights, nor will there be any equity dilution.
More straight forward is a cash based long-term incentive scheme (an "L-TIP"), whereby bonuses are achieved through the equalling and or exceeding of certain results, which may be spread over a number of years. In addition the bonus itself may be paid out over time, with the rolling residue being "lost" if the employee leaves or underperforms.
The simplest scheme is not a scheme at all – it will involve the straight forward offer of shares to selected employees. They will normally be required to pay for their shares, but if the offer price is subsequently held by the Inland Revenue to have been at an undervalue then there will be a benefit in kind tax charge. Cash-flow to meet the subscription cost is usually the biggest problem for the employee, and the risk of there being a tax charge with no benefit is the very opposite of an incentive.
Most share schemes are therefore designed to defer the date of both the tax charge and the acquisition of the shares. The most well recognised type of share scheme is the conventional employee share option. This will give the participant the right to acquire shares at a future date, but at a price fixed at the date of grant of the right.
Often the rules of the scheme will impose a performance target to be satisfied during the (typically) 3 year option period. The target might be the achievement of a listing or some other form of capital realisation, or it might be meeting annual profit targets. The flexibilities here are numerous.
The scheme can be designed to attract Inland Revenue approval. This will secure certain tax advantages, and in particular it will only be on the sale of the shares that a capital gains tax charge will be triggered. On the crystallisation of rights under a scheme that is not approved by the Inland Revenue an income tax charge will normally arise on the amount of the benefit. This will be regardless of whether the shares acquired are retained or sold. These tax points require careful planning.
Under an Inland Revenue approved "sharesave scheme" the grant of an option can be linked to a tax-approved savings contract so that, when the option is exercised, the employee will have saved sufficient money to meet the exercise cost. Alternatively, an Inland Revenue approved "profit-sharing scheme" will involve the gift of shares through an employee trust. The advantage is that the normal benefit in kind charge on the gift of shares can be avoided, provided the shares are retained in trust on behalf of the participating employees for a period of 3 years.
In the recent Budget it was announced that there is to be another form of all-employee Inland Revenue approved share scheme under which employees will be able to buy shares out of their pre-tax income, with the prospect of the employer providing free shares on a matching basis. This type of scheme will be reserved for all employees, and therefore will not touch the key employees specifically.
More relevant to that issue, it was also announced in the Budget that a new "enterprise management incentive" is to be introduced, although the details have yet to come through. These new schemes will go live from April 2000 after a period of consultation over the next several months, so it is a case of "watch this space" at the moment.
For reasons of simplicity, many employers prefer to adopt arrangements which are not Inland Revenue approved. The requirements for obtaining approval can be restrictive and run counter to commercial priorities. Also, the policy on share valuations may need to be more flexible than would otherwise be allowed by the Inland Revenue.
ESOTS and QUESTS
One of the points which will arise early on in any discussion about introducing a share scheme is how participating employees are to realise value. If the employer is a quoted company, then there will be a ready market for its shares. For the unquoted company, however, share valuation will always be more of an art than a science, and the liquidity of the shares will typically depend on the willingness of the existing shareholders to buy and sell at the appropriate time.
An employee share ownership trust ("ESOT") is commonly used to get round these issues. In essence, it is a standard form discretionary trust, the beneficiaries of which will be the employees and directors of the sponsoring company. The trustees will normally be drawn from the owners and senior executives, but may include employee representation. On the strength of funds received from the employer, an ESOT will be in a position to subscribe or buy shares. These shares can be warehoused in the ESOT in anticipation of using them to support share schemes.
There is another and more radical use of an ESOT. By dealing in shares, it can create what amounts to a mini internal market. This can be taken to whatever level of sophistication is required. It could be that share dealings into and out of the ESOT will take place on a regular basis, for example at the end of every quarter. Provision can be made in the articles of association to allow such share transfers to take place on a preferential basis and at a price linked to an agreed formula.
Most ESOTS are "unapproved"for tax purposes, but the scope exists to adopt a trust that has Inland Revenue approval. These approved trusts (known as QUESTS – qualifying employee share trusts) have certain tax benefits but operate within quite tight parameters. St Lukes is perhaps the most well known example of a company that has established a QUESTS, but a number of other leading marketing services companies have also done so.
However such vehicles really are trusts, they bring real responsibilities and disciplines: they cannot be seen as merely expedient devices to be used in an ad hoc and arbitrary manner. Therefore this type of arrangement needs to be very carefully planned to fit with the overall strategic business aims of the business, including making sure that:
it is structured in a tax efficient manner;
the profitability of the core business is not unduly depressed;
that any expectation that "the ESOT will provide" is likely to be matched by appropriate cash reserves or resources; and
employees fully appreciate the financial risks that may exist for them when agreeing to acquire shares for value.
Any development which involves changes in the equity structure of a business, combined with the managing of the expectations of key executives within that business, will be of the highest importance. Careful pre-planning is therefore essential, both to meet employee aspirations, but also to protect the established interests of the existing shareholders. That said, for many companies this is not a luxury, but a business necessity.