Attracting management talent is often an expensive and difficult exercise for start-up businesses. For starters, most of them don’t usually have the cash on hand to be able to afford to pay market salaries.
Combine this with the relatively high risk of failure and you can see why most start-ups are a fairly unattractive proposition for key talent.
Get daily business news.
The latest stories, funding information, and expert advice. Free to sign up.
One means of addressing this is to establish an employee share scheme by offering employees shares in the business, in lieu of receiving a higher salary.
Share schemes have a number of positive attributes:
- They provide employees with a reward for their efforts in helping the company develop during its formative stages.
- They assist the employer with their cashflow requirements.
- If administered properly they can align the goals of senior executives with the interests of the business.
- If the business succeeds the rewards can be high, compensating the employees for lower than market salaries.
However there is some downside. If the business fails the shares are usually rendered worthless. The other problem is that there is no active market for shares in small private companies.
This means that employees can’t sell or cash out their shares until the business either sells or lists which could be some time after the shares have been issued.
Finally, share schemes can be costly to establish and maintain and are difficult to administer, particularly after the recently imposed ATO reporting obligations.
If you believe an employee share scheme is the way to go for your business, consider my top five tips before setting it up:
1. Share schemes can be taxing
Changes to the tax laws affecting employee share schemes now see employees being taxed on shares or options issued at a discount to market value, in the income year that the share is granted.
Worst case scenario means the employee may have to write out a cheque to the ATO without having the cash to pay for it and without being able to sell shares to fund the impost.
Giving your key employees a tax bill with no cash is not exactly a good way to incentivise them.
There are exemptions and avenues for deferral but they are complicated and only apply in limited circumstances. It’s best to check with your accountant about how they work and whether they apply to your particular scheme.
For the employer, the value of shares issued under employee share schemes are generally counted as remuneration. This means that on-costs such as payroll tax and super may apply.
Advice should be sought to ensure your well-intended arrangement doesn’t become an unintended disincentive for anyone involved.
2. Know your rights
Be clear about what you’re giving away and what the implications of doing so might be. It’s important that both business owner and employees understand what’s being granted and how to manage the responsibility that comes with it.
For example, most common or ordinary shares will give shareholders the right to attend and vote at meetings, rights to access financial information and rights to dividends.
Do you want your employees to have all these rights? If not, consider issuing a different class of shares with limited or restricted rights. As the owner and majority shareholder, you don’t want to be in a position where key decisions can be frustrated by minority shareholders.
A well documented shareholders agreement should help overcome some of these problems.
3. Don’t give it all away up front
Vesting shares ensures the employee meets agreed requirements before completely owning the shares. Shares are issued a portion at a time, for instance 25% of the parcel being given is awarded each year over four years, as a means to retain the employee for an agreed period of time.
If the employee resigns before completing the four year term, they may only be entitled to 50% of the shares originally agreed would be granted. Alternatively you may decide the employee can only retain the shares while working for the employer.
4. Have a documented shareholders agreement
An agreement removes misunderstandings and gaps in understanding by covering all the conditions of the scheme in writing. The agreement should cover the following key elements:
- Class of shares and rights they afford the employee.
- Quantity of shares being issued.
- How you determine the value of the shares.
- A vesting schedule.
- Performance benchmarks and conditions.
- Minimum holding periods and what happens if the employee leaves early.
- Payouts, how and when an employee can cash in their shares either when they leave or during their employment.
- Transfer restrictions and beneficiaries.
- Change of company ownership circumstances.
5. Make sure you have the authority to issue shares
The ability to do so must be within the terms of the company’s constitution and shareholders agreement.
It’s recommended that you seek legal and accounting advice to ensure your share scheme does not contravene the Corporations Act or other financial services licensing rules and is executed in a manner that supports your objectives for implementing it in the first place.
Marc Peskett is a partner of MPR Group a Melbourne based firm that provides business advisory services as well as tax, outsourced accounting, grants support and financial services to fast growing small to medium enterprises.