There are many ways to keep employees incentivised. Good pay and conditions always help, but another way to motivate staff is to give them a real stake in the business.
It has become much easier in recent times for New Zealand based companies to establish employee share option schemes, thanks to the Financial Markets Conduct Act 2013. The Act sets out a compliance regime that those offering financial products for sale must follow, but Schedule 1 of the Act provides a specific exception for employee share schemes. This exception means that offers to participate in certain types of employee share schemes can now be made with only limited disclosure.
Employee share schemes are great – sometimes
Employee share schemes can work well, and can be relatively simple to implement. What better way to keep an employee incentivised than to give them the opportunity to take shares in the company?
But they are not the answer for every company. Not every company will want its employees to become shareholders. Unless the scheme provides for the shares issued to employees to be non-voting, employees will be entitled to vote at meetings of the company. Shareholder employees will also be entitled to receive information and reports, as well as dividends. Additionally, there may be pre-emptive rights issues to deal with on an ongoing basis.
Another problem with employee share schemes is that a company with 50 or more shareholders will be regarded as a Code Company for the purposes of the Takeovers Code. This may result in the company being subject to substantial compliance obligations in the event of a potential change of control. This could be an issue for a company with a large number of employee share scheme participants. There are ways of structuring employee share schemes to avoid this 50-shareholder problem, but they may add to the complexity of the scheme.
The exception in Schedule 1 of the Financial Markets Conduct Act 2013 is also quite limited.
- The exception only applies to employees, directors and personnel of the company or its subsidiaries. The exception cannot be used to grant shares or options to outside investors.
- Raising funds must not be the primary purpose of the offer.
- The number of financial products issued or transferred under all of the company’s employee share purchase schemes must not exceed:
- in the case of an offer of voting products or options over voting products, 10% of the voting products of the issuer as at the start of any 12-month period; and
- in the case of any other offer of specified financial products, 10% of the specified financial products of the company that are of the same class as at the start of any 12-month period.
This 10% threshold means that if the company does not have non-voting shares on issue prior to the establishment of an employee share scheme, the Schedule 1 exception will not allow for the issue of non-voting shares under that scheme.
Finally, the taxation status of some employee share schemes may be complex and problematic and may lead to uncertainty, depending on how that scheme has been structured. New Zealand’s Inland Revenue Department has been looking to overhaul the tax treatment of employee share schemes, and work is ongoing in this area.
Phantom shares – an alternative
So what about phantom shares? As the name suggests, a phantom share is not a real share in a company. It is instead a contractual right to receive a cash bonus upon achievement of some target or milestone.
So a phantom share scheme is really nothing more than a cash bonus scheme. No actual shares are ever issued.
Under a phantom share scheme, phantom shares typically vest in an employee over time, usually so long as the employee remains with the company. Vested phantom shares give the holder a contractually enforceable right to receive cash payments on certain events taking place. Phantom shares will usually be issued at an agreed value, normally being the market value of an ordinary share of the company.
There is no standard phantom share structure, but most schemes provide for either a regular bonus calculated on the company’s profit, or a share of any payout to shareholders upon a major liquidity event (for example, a sale of the company’s business or an IPO), or a combination of the two. In both cases, the bonuses payable is usually calculated on the percentage share of the company’s ordinary shares and vested phantom shares that the employee’s own vested phantom shares represent.
The regular bonus calculated on the company’s profit will sometimes be expressed as a share of the company’s EBIT or EBITDA, or it may be expressed as a share of the company’s declared dividends.
The liquidity event bonus is usually calculated by working out the effective uplift in the
value of the company’s ordinary shares as a result of the liquidity event, from the original agreed issue price. For example, if the issue price under the phantom share scheme was $1.00 and the liquidity event effectively valued up the company’s ordinary shares at $3.50, the employee would expect to receive a cash bonus of $2.50 per phantom share held.
Phantom share schemes are usually simple to implement, do not require any changes to the company’s share register, and are not generally considered by the Financial Markets Authority to give rise to an offer of financial products. This means that the compliance obligations of companies arising from the implementation of phantom share schemes are very limited. The taxation status of phantom share schemes is also relatively clear. In most cases the bonuses received by employees will be regarded as taxable income and treated like any other employment-related bonus.
The downside for employees is that they only ever receive a “phantom” asset. Shares are property, whereas phantom shares are only a contractual right to receive bonuses. Most phantom share schemes limit or prohibit the transfer of the phantom shares, and sometimes a scheme will permit the company to cancel even vested phantom shares on the occurrence of certain events (for example, dismissal of the employee for misconduct).
But phantom shares can be a great alternative to the traditional employee share scheme model, because they are so flexible, and can be tailored to suit just about any type of arrangement.
For more information about employee share schemes and phantom share schemes, please contact us.