The benefits and challenges of employee share incentives

Employee share incentives: John Lewis is well known for being owned by its workfoce. Photo: Geoff Moore/REX
John Lewis is well known for being owned by its workfoce. Photo: Geoff Moore/REX

Recent academic research looking into the impact of employee share ownership provides some fairly compelling data to support arguments that companies offering employee share incentives are likely to outperform those that do not. John Dormer guides us through some of the options available.

Benefits to employers and employees

From an employee relations angle, providing share incentives could be a much more effective tie-in to the business than salary and bonuses, while also ensuring that long-term interests become aligned with you as a shareholder. Shares also reward employees for generating sustainable long-term growth in value, as opposed to achieving shorter-term targets.

In terms of retention, share incentives are growing significantly in popularity and profile and there may well be defensive reasons for offering key employees shares – in short, if you do not offer them, then would alternative employers be likely to do so?

With the Government’s stated aim of creating a “John Lewis economy”, the climate is as good as ever to look at employee share ownership. Recent government initiatives have made employee share schemes easier to implement in terms of the legal requirements, and are also more tax efficient for businesses and employees.

From a financial point of view, rewards to employees via shares under government-backed arrangements can be received tax free or with just 10% tax being payable by the employee. This contrasts very favourably with cash bonuses where up to 47% of any benefit can go straight to the taxman.

Coupled with tax savings to businesses, tax-efficient share incentives could provide up to £1.27 of reward to the employee for every £1 of cost to shareholders/the business. This significantly exceeds the return on cash bonuses that could be as low as just 46 pence for every £1 of cost.

Shareholder rights

Importantly, control can still be fully retained by existing shareholders by using share options or employee shares with little or no voting say. Any holding of shares/options by employees should also be subject to restrictions on transfer and forfeiture to ensure that the shares cannot be transferred outside of existing shareholder control and are also forfeit in the event that the employee leaves the business.

Some owner-managers are concerned about suffering dilution to their existing value in the business. Employee shares need not result in any economic dilution through the use of specific classes of shares, which allow the employee to benefit only in future growth – thus ring-fencing current value for existing shareholders.

Unlike cash bonuses, to ensure that employee share incentives are genuinely valued, there must be some prospect of the employee being able to “cash in” his or her shares. In many cases this is through a sale to a third party. For businesses that are unlikely to exit, internal market arrangements can be created, possibly involving the sale of shares back to shareholders/the company to enable the employee to realise the value in his or her shares.

Key to the success of any arrangement will be ensuring that the quantum and any targets attached to the incentives strike the right balance. The incentives themselves must be of a meaningful enough size and with sufficient potential upside to make them attractive to the employee. Appropriately designed performance targets would also be worth considering to ensure that performance and reward are properly linked and that shareholders get value out of the incentives too.

Share incentives can cause complications where these key issues are not properly addressed. With appropriate structuring, however, they can provide a genuine tie-in for employees and ultimately help generate greater overall equity value for business owners.

John Dormer

About John Dormer

John Dormer is a partner at the law firm Wright Hassall.
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