A major issue for some Employee Ownership Trusts is attracting senior staff to work in the business following the transition to employee ownership. Non-EO companies may be planning for their “exit event” and will have an opportunity to grant share options to staff which can be exercised and the shares sold on a future sale. An EOT-owned business will not be planning for a future sale and has to think more creatively in incentivising its senior staff.

The questions raised in this article were the subject of our last EOT Roundtable events held in Cardiff and Narberth, with both events triggering a wide-ranging debate.

The “ethical” debate

An EO business will have to accept that it wishes to incentivise its senior staff in a different way compared to the rest of the employees in the company. The use of shares as an incentive can be an emotive topic particularly if the company is 100% employee-owned via the EOT. The trustees have to be comfortable with the idea of some employees becoming shareholders, even if it is for a short length of time.

A wider debate could be generated as to whether the company wants to follow a hybrid model and have all employees holding a direct shareholding. Managing direct shareholdings is a topic for a further article as it raises complicated issues regarding issuing shares to staff, good and bad leavers, and acquiring the shares from departing employees (involving the valuation of shares and forced sales).

Tax issues

The most important point is that the EOT must, at all times, own more than 50% of the issued share capital of the company. A failure to meet this condition is a disqualifying event and will trigger a capital gains tax charge on the former owners or the EOT depending on the length of time from the purchase of the shares by the EOT. The EOT must consider the dilutive impact of any shares that could be issued to satisfy the exercise of a share option.

Share options would have to be satisfied by the issue of new shares by the company. The transfer of shares from the EOT to selected employees following the exercise of the options would breach the equality treatment of the EOT and be another disqualifying event.

The exercise price of the options should be set at the market value of the shares at the time of the grant of the options. Any discount to the market value would create an income tax charge on the option holder at the time of the exercise of the option. Valuing the shares can be extremely tricky. Issues to consider include:

• Discounts for a minority shareholding to reflect the small percentage of shares. The same discount should apply on the eventual sale of the shares (unless part of a sale of all the shares in the company by the EOT which is pretty unlikely). The EOT trustee would be unlikely to agree to a minority discount being applied to the exercise price and no discount being applied on a future sale by the option holder.
• A reduction in value of the shares to reflect the amount of any deferred consideration payable by the EOT to buy the shares that are outstanding. The deferred consideration is a liability of the EOT and may not be reflected on the balance sheet of the company issuing the options. Should the outstanding consideration be taken into account?
• The rights of the shares? If the intention is to pay a dividend on the shares following exercise of the option, has the potential dividend been reflected in the valuation of the shares? Advisers need to consider the application of the restricted securities regime and the value of the shares. Do the shares have a restricted value due to limits on capital value as a form of growth shares? Growth shares are usually a one-off issue of shares as once the hurdle value has been satisfied, the growth shares become increasingly valuable.
• EMI options do allow for the market value to be agreed in advance with HM Revenue & Customs (“HMRC”) who may be very interested in any “clever” valuation methodology in reaching a proposed valuation of the shares under option. Without full disclosure being made, HMRC would be able to revisit any valuation.

Practical issues

The EOT trustee will want to see performance conditions linked to company performance before a large proportion of the shares under option can be exercised. The senior staff should not expect to be able to exercise the options for “doing their day job”; there has to be a demonstrable increase in company value. The number of shares that can be exercised could be subject to a sliding scale.

Provisions regarding option holders leaving should be considered. A hard “in it to win it” rule with the options lapsing on cessation of employment for any reason is easy to understand and can be explained to the wider workforce. The EOT trustee may want to see a requirement for the option holders to retain shares in the company after exercise (allowing a sale of some shares to pay the exercise price) to ensure an alignment of the interests of the senior management team with the operation of the company and employee ownership values.

The share options are worthless without an opportunity to sell the shares and realise a capital gain. The company will have to establish an internal market via a separate employee benefit trust (“EBT”). The EBT will be similar in concept to the EOT but will not be subject to the equality treatment and the rules on disqualifying events. An EBT can act as a warehouse for shares which can be used to satisfy the exercise of share options in the future. The EBT may have its own tax liabilities if the shares it holds increase in value. The EBT has to be funded by the company.

The previous owners of the company will not want any options being exercised and money going out of the company before they have been paid their deferred consideration. The sale agreement may contain restrictions on the grant of share options and at the very least require the consent of the sellers.

What do the senior employees want?

There should be a discussion with the senior employees as to what they want to be motivated to stay (or join) and work hard. The views of the senior employees may be very different from the existing management team who possibly sold their shares to the EOT. Would the senior employees prefer cash now linked to performance with the higher income tax charges or the prospect of a possible gain subject to capital gains tax (and hopefully lower rates of tax) at some point in the future?

It is very easy to go down the route of developing a share option scheme and then finding out that it is not something that motivates the senior management team – they would prefer more immediate cash.

Conclusion

The grant of share options in an EO environment is not straightforward and requires a lot of thought and time to implement properly. Share options and the related complexity may not provide the required drive and impetus for the senior employees who may prefer to receive cash, despite the higher tax rates that apply to income rather than capital gains. This was very much the conclusion from both EOT Roundtable events with many of the attendees (including senior managers) deciding to put the idea of share options in the “too difficult” box and adopt a “keep it simple” solution of cash bonuses.

If you are not put off by the complexity of share options for EO companies, please do get in touch. We have put share options in place for a number of EO companies.

If you’ve not yet booked your place at the forthcoming employee ownership conference on 1st May, you can book on here