The concept of employee share ownership has been raised by a number of business owners in recent discussions, each with their own motivations and intended structures.  What these discussions have clearly demonstrated is both the desire to invite key staff to share in the fortunes of the business, but also the wide disparity in ideas around the why and how.

At a fundamental level, employee share ownership can provide significant advantages to the SME.  The most prevalent is in the retention of key employees, creating a situation where these critical resources have some skin in the game and are more likely to demonstrate commitment, loyalty and enhanced productivity.  Equity participation is also often used as a lure in the recruitment process, enticing talent who might otherwise be lost to larger, better-resourced organisations with more lucrative remuneration packages.

In the context of an exit plan, employee share ownership can be a vital component in recruitment and retention.  Potential buyers will see more appeal in a people-driven business that has a mechanism for locking in its key performers compared with one where the barriers to exit are fairly low.

However, there are numerous downsides to consider, so consider the following fundamental guidelines for Employee Share Ownership Plans (ESOPs):

1. ESOPs are at their most effective when tied into a planned exit.  Employee share ownership without a liquidity mechanism is virtually pointless and certainly not cost-effective.  It doesn’t take long for the emotional attachment to share ownership to wear off, to be replaced by the reality that it’s not actually worth anything if you can’t sell it.  If it’s a broader distribution of profits you’re after, there are simpler and less risky ways to achieve dividend participation, such as profit share pools.

2. Establish share ownership without rights.  Employees with a slice of equity in a SME often feel an entitlement to a seat at the table when it comes to determining business management and strategy.  Some even feel they have the right to boardroom participation.  Set the ground rules early in a formal Shareholdersers’ Agreement – their shareholding is passive and granted so that they can share in the upside when the time comes to sell.

3. Don’t “give” equity.  To anyone.  Period.  Equity must be earnt or purchased, either through salary sacrifice, cash purchase or performance schemes.  Not only does the tax office demand their cut (equity in lieu of cash is still deemed taxable income), but it can also devalue what you, the business owner, has worked so hard to achieve.  The equity has real value, you should not just give it away for nothing.

One of the more effective and least risky ESOP structures to consider is one where a unit trust is established to own a specific percentage of the company’s equity: 

  • Employees can then earn or purchase units in the trust, to increase their own share of its equity holding. 
  • If the trust’s shareholding is signficant, you may even incorporate in the Shareholder Agreement or Constitution a structure whereby a small number of unitholders are elected as representatives on the business’ strategy committee. 
  • Units may be tradeable or redeemable (or even forfeited) if a unitholder were to cease their involvement with the business. 
  • If the company were to pay dividends, the trust would distribute its share in proportion to the unitholders. 
  • There is no limit to the number of units that can be issued, so employees have to continue to earn or purchase units on a periodic basis to avoid diluting their entitlement.

Employee equity participation can be a very valuable tool for retention and attraction of key talent, and if done properly and with great care, does not have to be a yoke around the owner’s neck.  The term “golden handcuffs” is used widely in the context of ESOPs; just make sure yours doesn’t become a ball & chain attached to your own ankle.