Employee Equity in Private Businesses The AEOA has as one of its key objectives the promotion of employee equity in private companies, especially though broad-based employee share ownership plans (ESOPs). ESOPs of the "all employee" variety can have a major impact on improving the performance of small business pty ltd companies. There is much evidence that correlates broad-based employee ownership and participation with measurable increases in productivity in the workplace (see "Employee Involvement"). On the other hand, offering employee shares in a company to just a few key employees is likely to have no - or even a negative - impact on the business. To support development in this area, the following resources are provided to assist: 1. Retiring business owners looking to transition their business to their employees as part of a succession plan. 2. Start-up businesses/companies where the owners are looking to provide equity to employees as a way of financing the business, improving company performance or creating an incentive to attract and retain employees. 3. Ongoing, successful businesses looking to cut their employees into a proportion of the shares/capital of the company as a means of rewarding and retaining employees or to promote the "co-ownership" of the enterprise. For those interested in employee buyouts of private companies where jobs may be under threat, please go to our "Australian Employee Buyout Centre" page for more information. A private company looking at expanding employee equity (based on the ordinary shares of a proprietary company) may need two or three types of employee share plan to ensure "broad and deep" employee ownership in the one business. For example, one Australian private company in Australia has (i) a $1000 "Tax Exempt Plan" for all employees, (ii) a deferred option plan for key skilled staff, and (iii) a loan based plan for the three senior "new owners" (all managers).   If you need professional guidance on any of the matters outlined on this page, please seek the advice of any of the consultants on our ESOP Consultants page.  It is likely that you will need to seek expert tax advice on any of the share plans detailed below in relation to your particular circumstances. This includes advice about the tax concessions available for such plans, as well as any CGT implications. Well designed employee share plans can also be carried through to IPO if you decide to take that route. For succession planning ESOPs, you might also want to view the ESOP Forum on "Business Succession of Ageing Baby Boomers" . You might also find useful the forum "Going Ahead with your ESOP" if you are considering starting up an ESOP and want to know how ESOPs work. If you want to learn more about the advantages and disadvantages of ESOPs, see our "AEOA Policy" page. For more advice on ESOP tax concessions, see the Australian Government web-sites on our "Links" page.  Brief descriptions of the "Leveraged ESOP" (which is useful for ESOP based business successions), the "Employer Funded Employee Share Plan" (which is useful for expanding employee equity in a private company) and the "Options Plan" (which may help finance the start-up costs of a new venture) have been provided below. Recent Articles and Case Studies on ESOP based Business Successions   Selling Your Business to Your Employees – ‘My Business’ magazine, June, 2007.  Small Business: Selling Out to Your Employees – ‘Sunday Times’ (UK), 28, November, 2004   Founders out, employees in! - Employee buyouts are assisting retiring business owners –‘Ethical Investor’ (Australia) magazine, July, 2006. Bringing in the New: An Ownership Succession ESOP at Hugh Hamilton Ltd - ‘Shared Ownership’ magazine, (Canada), Summer, 1998. A Novel Plan to Pass on Your Business – ‘Daily Telegraph’ (NSW), 12 October, 2004. Future Bleak for Small Business Owners Set to Retire – Media release, CPA Australia, 27th April, 2004. Selling a Business to its Employees - Newsletter Article, ROCG (Australia), 27th December, 2007. Redundancy? No! We bought the company - 'The Guardian', UK, 12th January, 2008.  From Colleagues To Owners: Transferring Ownership To Employees - Employee Ownership Association, UK, April, 2009   NEW Business Succession, Retiring Owners and Buyout Options: The Public Policy Perspective – Policy Paper by The Mercury Centre for the 'What will happen to the SME sector when the baby boomers retire' workshop at the International Council of Small Business Pre Conference Forum, Melbourne, 16th June, 2006.   Business Succession through ESOPs: Key Web-site Links   Succession London (UK) Business Succession: Delivering Employee Ownership (UK) Business Succession Program, Ohio Employee Ownership Centre (US) Businesslink (UK): How to Achieve an Employee Buyout Employee Ownership Association UK: FAQs About Selling a Business to Your Employees. Recent Articles on ESOPs in Private Australian Companies   Biolytix Technologies – ‘My Business’ magazine, September, 2007.   Biolytix Technologies Pty Ltd  - address to the AHRI National Convention, June, 2007. OBS Pty Ltd – ‘Dynamic Business’ magazine, April, 2007.  DMC Outsourcing Pty Ltd – Sydney Morning Herald, 21st May, 2005 Gardner Smith Pty Ltd – Daily Telegraph, 5th June, 2007. Geared ESOPs – Thomson’s Weekly Tax Bulletin, 27th August, 2004. Private Company ESOP Links   Biolytix Employee Share Ownership Plan (TBESS).   Topsy-turvy companies: where workers rule - The Australian Financial Review, 21st August, 2007. The Leveraged ESOP   When it is time for an owner to sell all or part of a business, either because of retirement or moving on, there are several choices. These include family succession, a trade sale, liquidation of assets, listing on the stock exchange, selling to management or selling to the employees (which will include management as employees). There may not be a willing family member to take on the business. A trade sale can be time consuming, costly and will open the business up to intense scrutiny. Selling to a third party may result in the facility being closed. Even if the business is kept open, key staff may be replaced when ownership is transferred. Liquidation of the assets will almost certainly not take into account goodwill (reputation or customer loyalty) and is likely to yield the lowest return. The last option – selling to the staff – is not one which most owners think about, but it can be an efficient route for business transfer, for maximising the value of the business, for preserving goods and services within the locality and for safeguarding jobs. SME business owners face significant risks through a lack of proper succession planning, such as erosion of business value on exit, the loss of key talent to competitors or even the closure of the business. Employee share ownership plans can provide a solution to challenges such as these. In particular, they can facilitate ownership succession whilst ensuring business continuity and preserving business value and jobs. The leveraged ESOP is an ideal tool for an employee buyout or buy-in.  It is well suited to succession planning through providing retiring owners with a way of selling the business to their employees. A leveraged ESOP looks something like that in the diagram here      The following is typical for an ESOP based employee buyout:   ·         Shares are bought by an ESOP trust (Employee Share Ownership Trust).   ·         The trust is financed by contributions from the company itself, or from a loan which is repaid from company contributions.   ·         If the trust is financed by the company over time, it may take some time before the trust has received sufficient funds to finance the purchase of all or even a majority of the issued shares in the company.   ·         If the trust is financed by a loan, this may enable it to acquire a majority shareholding or even all the issued shares in one go.   ·         The trust may retain some or all of the shares it has acquired on a long term basis, or it may distribute shares to employees over time. The leveraged ESOP - where the employee share trust is financed by a loan which is repaid by company contributions - is a recent innovation in Australia, though it is used extensively overseas. It is a fully financed model enabling the buyout transaction to be accomplished out of future corporate earnings rather than current employee savings (though the employees can make contributions to the employee share trust to help repay the loan from their pre-tax income).  The leveraged ESOP allows the employer to borrow funds to provide funding to the ESOP. The ESOP trustee uses the funds to purchase shares in the employer. The retiring owner receives the proceeds immediately and the company pays off the loan over time through tax-deductible contributions to the ESOP.  There are also a range of other advantages for share plans where employee shares are owned through a trust. However, one possible disadvantage is that employees may be taxed on their gains under income tax rates rather than CGT. There have been several examples of leveraged ESOPs along the lines above in Australia in the past few years. (For more information on "Employee Share Ownership Trusts" and their tax treatment, see the discussion forum "Going Ahead with Your ESOP" ). Employee Ownership for Private Companies: Alternatives to Leveraged ESOPs When people think of employee ownership, what often comes to mind are employee share ownership plans (ESOPs) as described above, where a trust is set up to borrow funds from a third party and with these funds acquire shares in the employer’s company. Because the ESOP is ‘leveraged’ it is very effective for buying employees a significant stake in the firm and paying for it in a comparatively short time. ESOPs are becoming popular in all types of businesses and are now being discussed in the media. Yet ESOPs with all of their benefits are not the answer for all companies. The leveraged ESOP is an ideal tool for an employee buy-out or buy-in and is well suited to ‘succession planning’ (by providing retiring owners with a way of selling the business to their employees), but many small companies find it difficult to absorb the cost of establishing an ESOP. Others are not profitable enough to benefit from the tax advantages. Others may lack the cash flow to handle the contributions needing to be made to the ESOP. Still others may be less than comfortable with the rules that govern ESOPs and may be looking for a different way of spreading ownership. Fortunately, there are a number of ways that companies can turn employees into owners. These possibilities include share purchase plans, profit sharing and share options plans. A company can also convert itself into a cooperative. If none of these methods meets a companies needs, it can also create its own plan. BASIC PLAN DESCRIPTIONS The easiest and most flexible way to start an employee ownership program is through non qualifying share purchase plans, either via employee savings, employer contributions or through some kind of loan arrangement to employees. Because they need not qualify for any special tax benefits (eg: under Division 83A of the ITAA), these plans may not be subject to the same regulations as qualifying plans and may therefore be easier and cheaper to implement. Share bonuses or share discounts can be taxable to employees, but deductible to employers. They can be designed to meet any objectives that a company has. The primary decision a company has to make before establishing these types of plans is whether to loan funds to employees and what discount on the shares might apply. The answer to these questions is based on company circumstances. Once the decision is made, a company needs to establish an allocation plan (including loan terms and repayments) and consider how to handle repurchasing the shares if the employee leaves. There are no formal rules governing these plans – as there would be with a qualifying plan – but a company must pay close attention to the issues indicated if the plan is to be successful. A second possibility is for a company to establish a share option plan. Share options have traditionally been the most popular form of providing executives with an ownership interest. They are increasingly being used to provide an incentive and ownership interest for a wider circle of employees. Share options give participants the right to purchase company shares between certain dates, for a fixed price by the company at the time the options are granted. The amount of shares each individual can purchase is generally tied to a percentage of salary and the employee is under no obligation to act on the option. Profit sharing plans share a portion of company profits with employees, and can also be used to share ownership. There are two types of profit sharing plan. The first are simply short term cash bonuses allocated under various profit or gain-sharing arrangements. The second are employer funded share plans. In the latter plan, a portion of company profits is allocated to purchase fully paid shares for employees. It is only these plans that can be used as an ownership vehicle as profit is shared via shares rather than cash. Finally, there are worker-owned cooperatives, which are based on a one person, one vote philosophy. Only workers can be members of the cooperative, but cooperatives can hire non-member employees. Cooperatives are seen most frequently in smaller businesses and if those involved are comfortable with the structure, they can be used effectively as a start-up vehicle. CONCLUSION Choosing an employee ownership plan can be a confusing and difficult decision for a private company to make. There are numerous issues that must be considered and many details to be understood. For an examination of these issues - as well as information about plan rules and regulations, related taxes, plan structures and possible problem areas – you need to discuss your circumstances and interests with consultants who specialise in establishing and maintaining the types of plans and ownership arrangements discussed on this page. Further details on some of the alternatives for private companies wanting to introduce employee equity are decribed below.   The Employer Funded Employee Share Plan   The acquisition of shares by employees can cover such schemes as: 1. Partly paid share plans 2. Fully paid share plans 3. Option plans 4. Replicator share plans (ie: shadow/phantom share plans) The "Fully Paid Share Plans" come in three varieties - financed by loans to employees (Loan Plans), financed by employee contributions (Savings Plans) or financed by company contributions (Employer Funded Plans). In the employer funded share plan, a proportion of company profits is allocated to purchase fully paid shares for employees. The shares can be newly issued or purchased on the stock market and carry full voting rights and rights to dividends, bonus and rights issues. THE PLAN Employer Funded Plans may take many forms according to the philosophy and objectives of the employer: • The shares are acquired as an added financial benefit to the employee (as an extension to profit-sharing or gain-sharing). • Employees are not required to risk their own money or savings, but the plans have the flexibility to allow for those employees who wish to do so, to contribute through some ‘salary sacrifice’ arrangement. • These plans are usually related to company performance, in that the amount the employer contributes towards the purchase of shares on behalf of employees is charged against annual profits (provided certain performance goals are achieved). For example, these plans may work as follows: - An employer uses say 5% of annual profits to purchase new or existing company shares on behalf of employees. - An employee is allocated a number of shares (say 500) according to certain criteria (see “purchase criteria” below). - 500 shares are now held in trust for the employee, and the employee receives dividends on 500 shares. - Next year, the employer again uses 5% of annual profits to purchase company shares on behalf of employees. - The employee may add, say, 1% of their gross pay plus 3% of any gain-sharing bonus and productivity bonus. - The employee is allocated a number of shares, say 600, according to certain criteria (see purchase criteria below). - 1100 shares are now held in trust for the employee, and the employee receives dividends on 1100 shares. - As this continues from year to year, the employee’s share holding increases and so do the dividends. PURCHASE CRITERIA • A qualifying period of employment, usually one or two years of permanent employment with the company. This could be full-time or part-time employment, not casual employment. • The number of shares allocated to each employee is usually determined by years of service, annual pay and/or management policy. This also depends on annual profits. • The shares or share certificates are usually held by the trustee until they are withdrawn by the employee or the employee retires or leaves the company. In some cases, the employee must sell the shares on leaving the company. SELLING CRITERIA This is fairly flexible and ranges from no minimum period to a minimum period of twelve months or more. TAX LIABILITIES The tax assessment is very simple with these plans: • Employers receive a tax deduction for the amount they subscribe towards buying the shares, because it is considered a cost of running the business. (This is only possible where the scheme involves shares acquired by an interposed entity like a trust). • Employees generally don’t get an up-front tax assessment for receiving the shares but, as per the new Division 83A of the Income Tax Assessment Act, employees pay tax when they withdraw shares from the plan. (For a complete overview of the new tax legislation enacted in December, 2009 - Division 83A - and all the conditions needing to be met to qualify under the legislation - see the Australian Tax Office's new web-page  "Reforming the taxation of employee share schemes".  ).   There is a seven year time limit for those who are members of a “Tax Deferred Plan” and members of an “Tax Exempt Plan” pay no income tax on shares allocated up to the maximum discount amount of $1000 per year. Also, income tax must be paid on the full gain derived by the employee, compared with most investors who can take advanatage of the 50% CGT concession on any capital gains. • Dividends are paid to the employee through the ESOP trust. The usual income tax rules apply here, including that in most cases any franking credits should flow through to the employees. CONCLUSION The benefit of such plans is that it costs employees nothing to become involved, so participation rates can be as high as 100%. The idea of getting ‘something for nothing’ sometimes means that owning shares under these conditions is initially regarded as a bonus, or savings. However, as time passes the ownership ethos may emerge. A disadvantage of such plans is, if new shares are issued, will be to dilute the interests of shareholders in the employer - or, alternatively, if existing shares are acquired, the effect will be a loss of corporate cash flow to existing shareholders, rather than providing more investment in the workplace.   New Ventures, Start-up Companies and Employee Share Options  An option granted by a company is a ‘right’ to buy an unissued share from the company at an agreed price at a specified time in the future. When the option is “exercised”, the option-holder is using his or her right to take up the shares. So, if the share price has increased above the agreed exercise price, the shareholder will make a profit. If the share price goes below the agreed exercise price, the shareholder normally would not exercise the option and it would lapse (ie: expire at the end of the specified exercise period). The issue of options to employees in new ventures provides a cost-efficient way for shareholders to attract and remunerate people who have a pivotal role in creating value for shareholders. It also enables the new venture to be “financed’ by taking pressure off cash flow in the venture’s early stages through substituting a share of the future wealth of the business for salary or bonus payments. THE PLAN Employees may be given options at nil acquisition cost or at a minimal cost of say, 1 cent. These options must be exercised within a certain time frame, or let lapse. An option is not a share: a free or low-cost option still requires the option holder to pay for the share in the future, if he/she exercises the option, unless the exercise price is zero.  A very simple example of how an Option Plan may work is as follows: An employee is offered 500 options @ 1 cent each for shares which can be exercised to acquire a share at $4:00. 500 options at 1 cent = $5, payable when the options are granted. Two choices now (i) Exercise the options within 5 years, or (ii) Let the options lapse at the end of 5 years and lose $5. Exercise price = Share value at time options are granted less 1 cent = 500 x $3.99 = $1,995 If the employee decides to exercise the options, this amount must be paid. If two years later the current market value of the shares is $4.75, the total value of the shares is $2,375. The employee may sell 420 shares to pay the exercise price (420 x $4.75 = $1,995). This leaves the employee with 80 shares. (Note that, if sold, there will also be a tax liability on the profit ($315) from the sale of 420 shares, ie: $0.75 x 420 = $315). PURCHASE CRITERIA • A qualifying period of employment with the company maybe required. Employment could be full-time or part-time, but usually needs to be permanent rather than casual. • The number of options offered is usually determined by annual pay level or management policy. SELLING CRITERIA • The options are usually not negotiable. An employee can either exercise them (ie: to purchase the shares) or let them lapse. • There are usually no restrictions on selling the shares which are acquired by exercising options in companies listed on the Stock Exchange. However, in private companies there may be rules on selling shares and possibly using an “internal market” for the shares. TAX LIABILITIES Generally speaking - and this applies to all employee share plans – careful attention to proper design can influence the amount of tax payable and the timing of their payments. For the employee, the tax liability works in the following way: • If the employee elects, options may attract tax upon acquisition; • Otherwise, options would be taxed usually when exercised, or upon cessation of employment if that is earlier; • Capital gains tax may also be payable when shares are sold on any gain in value since the time the options were first taxed; CONCLUSIONS Options Plans have some advantages and disadvantages. For example: • Employees acquiring options may not ever convert them into shares, so this could be seen as defeating the purpose of creating a sense of ownership and belonging; • Options do not normally provide rights to attend and vote at shareholder meetings, until they are exercised and shares issued. This means that until such time, employees are not truly participating in the responsibilities of ownership and control. However, some employers may feel it is appropriate to maintian existing control, eg: family businesses or tightly held companies. • Options carry minimal risk because, should the share value fall or the company go into liquidation, the option holders do not have to bear any losses, except for any nominal amount paid to acquire the options in the first place; • Options maybe safe in that there can be little ‘downside risk’ for the employee; • Options plans have typically been used to attract and remunerate key executives, but they are sometimes now being made available to most staff in order to provide a more equitable distribution of employee shares; • Options dilute the interests of shareholders - especially if they are free of charge or issued in large numbers - and so an ESOP using options may not obtain shareholder approval if not properly designed. Most options plans allow the employee to sell their shares after the specified time qualification or vesting period, and subject to general sale restrictions contained in the employer company's constitution or any applicable shareholder agreement. If these requirements are met, employees may be permitted to sell a portion of their newly acquired shares immediately to cover the funding of the "exercise price" and any tax bill.   Special Considerations for Unlisted and Private Companies. The following is from the web-site of the Employee Share Ownership Development Unit, Department of Employment and Workplace Relations (link: "ESOP Planning" ): The Corporations Act, taxation laws and Accounting Standards apply to all companies considering an ESOP, whether listed or unlisted, public or private. In many cases these regulations are more onerous and therefore more costly to comply with for unlisted companies than they are for listed companies. Some of the reasons for this include: • unlisted companies have no ready ‘market’ for their shares • stock exchanges set out the rules dealing with many rights and entitlements of shareholders, eg: what happens in the event of a change in control. Unlisted companies are not governed by these rules, but need to deal with many of the same issues • listed public companies are required to disclose financial and other information on a continuous basis, which means investors, including employee shareholders, are better informed. The Corporations Act provides certain relief from specific information disclosures for listed public companies that may not be available for unlisted companies In summary, the key areas of special consideration for unlisted companies include: VALUATION ISSUES For listed companies, the stock exchange provides a ready ability to determine the market price of a share. Unlisted companies do not have access to a market, and therefore, must rely on values determined by an approved valuation method. This can impose additional costs and complexity. LIQUIDITY Most shares in listed companies can be freely traded on the stock market. There is usually no ready market for shares in unlisted companies. Therefore, in order to provide liquidity for ESOP participants an appropriate mechanism for buying and selling shares needs to be created. Again, this can impose additional costs and complexity. MINORITY ISSUES The proprietors of many private companies need to have full control of their company to satisfy borrowing covenants, estate planning, tax and stamp duty reasons. It may be necessary for private companies to regulate an employee's rights under the plan to ensure full control in the event of dilution arising from an ESOP, eg: through a ‘Shareholder Agreement’. CHANGE OF CONTROL (for instance through takeover, initial public offering (IPO) or trade sale) Change in control provisions for listed companies are regulated under the Stock Exchange Listing Rules and the Corporations Act. Plan rules to deal with all the possible change in control circumstances need to be precisely and carefully drafted for unlisted company ESOPs. PROSPECTUS AND OTHER RELIEF PROVISIONS In certain circumstances the Australian Securities and Investments Commission (ASIC) provides specific relief for listed public companies in respect of Corporations Act prospectus requirements and certain licensing (giving financial product advice and dealing in & holding of financial products) and hawking requirements. While some class relief is available for unlisted companies any substantive disclosure and licensing relief for unlisted companies is usually dealt with on a case by case basis. This involves matters like the lack of readily available financial and other market information on a particular company. PRIVACY OF INFORMATION An effective ESOP often relies on a full and complete disclosure of a company's financial performance to reinforce the aims/benefits of the ESOP to plan participants. Unlisted companies, including private companies, need to be mindful of the serious implications of restricting or censoring key financial information in the interests of preserving privacy. A trustee of an ESOP trust may require an Australian Financial Services Licence, although ASIC provides some Class Order licensing relief in some circumstances. USE OF TRUSTS A trust is often used to hold shares on behalf of employee participants in ESOPs. Trusts are used for a variety of reasons, including: • to administer the various performance and/or vesting conditions that can apply to an ESOP. This is particularly important for share offers that are subject to forfeiture (eg. deferred share benefits) • to enable the orderly and cost effective acquisition and disposal of small share holdings. This is particularly important for small thinly traded stocks and/or for foreign resident employee participants • to ensure a company can adequately maintain and provide sufficient and correct information to employees ensuring they are aware of and are able to comply with their taxation obligations simply and easily • to enable a company to control and manage its share registry costs. (For more information on "ESOP Trusts", see the discussion forum "Going Ahead with Your ESOP" ).    It is recommended that you seek professional help from any of the ESOP Consultants who are members of the AEOA on the design and implementation of employee share plans of the types described above, or on any of the "special considerations" issues. The AEOA would be happy to provide more information on private company ESOPs and, if appropriate, refer you to others for expert advice.

Username   Password       Not a member? Join Now!