Planning for the end
Interest in Employee share ownership plans (ESOPs) has increased dramatically in the last 12 months as business owners seek to ensure their workforce is aligned, motivated and focussed amid the disruption to work arrangements brought on by the COVID-19 pandemic.
We have seen a 400% increase in enquiries from small-to-medium enterprises (SMEs) about how best to offer ESOPs to their employees, with many business owners noting that the demand is coming from the employees themselves. Increasingly, staff want to own equity in the business they work for, and this can have significant benefits for both the business and its owner.
Even before 2020, demand for ESOPs was strong, prompting the government to launch two separate enquiries to enhance the effectiveness of them. As a result, in 2015, employee share scheme (ESS) tax concessions were announced, leading to growing awareness and improved take-up. And, in May this year, further changes to make it easier for businesses to offer ESSs to their employees were announced as part of the Federal Budget.
WHAT ARE ESOPS?
An ESOP is a mechanism to allow employees to own a share of the company they work for.
There are different types of plans based on the size and structure of the business and what the business owner hopes to achieve from offering one. ESOPs can be suitable for both private and public companies, large and small. They can be particularly useful as a succession planning tool for owners of SMEs who are starting to think about their eventual exit from the business and want to maximise its value.
The academic research around ESOPs is overwhelmingly positive. Research published by US-based not for profit Certified EO found that employees earned more, stayed longer, were more productive and far more engaged as equity owners. The research also found a third of job seekers were more likely to apply when they learned the company was employee-owned, and almost half of consumers were willing to pay a premium price.
HOW DOES AN ESOP WORK?
There are several different types of plans, including one specifically designed for start-ups. The definition of a start-up is very generous: less than 10 years old, less than $50 million turnover, not listed and an Australian resident taxpayer. Many Australian SMEs would qualify.
If a firm does qualify, then there is no tax until the sale, as long as the firm issues the shares at less than a 15% discount, employees each own less than 10% of the equity and hold the shares for three years, and the plan is broadly based (available to at least 75% of employees with more than three years’ service).
If a firm is not a start-up or does not meet the criteria then a model that utilises a trust may be a better option. A trust would allow the company to set up an ESOP, invite key employees and then fund the purchase in three ways: have them buy-in using cash or savings, earn in using a profit share-funded model based on improved business performance, or take advantage of the various tax concessions ($1,000 tax-free and up to $5,000 salary sacrifice) to contribute.
Additionally, for some businesses, it is possible to accelerate the plan using debt. Leveraged ESOPs are popular in the US and are becoming increasingly so in Australia.
The trust structure can include good leaver, bad leaver rules and the ability to discount the value of shares when people leave early. It can allow employees to hold shares in a family trust, which cannot be done in the start-up plans.
The trust structure is becoming popular among privately-owned businesses. In the last three years, we have implemented over 50 of them.
EMPLOYEE REMUNERATION MODELS
One of the most critical aspects of business is how to pay for the team. Employee behaviour is directly influenced by the way staff are rewarded and this is not an area to get wrong. The ladder to equity in Chart 1 outlines the five steps to building a remuneration structure.
The steps on the ladder build up a robust remuneration model without the various issues that poorly designed models encourage, such as discretionary bonuses, misaligned targets and silo behaviour.
ESOPS FOR SUCCESSION AND EXIT
A recent MGI Family and Private Business Survey revealed that 60% of private business owners are approaching retirement and the ensuing transfer of ownership of assets and business equates to approximately $607 billion.
With baby boomers reaching 65 at a rate of over 5,000 per week, many business owner clients will be heading for the exit over the next decade.
Strategic succession planning via a carefully implemented ESOP means firms have a detailed and documented plan covering every aspect of the business that continually moves closer to the ultimate exit outcome.
However, most business owners are so caught up in running the business at a day-to-day level that they do not have the time, effort and attention to focus on the end outcome.
Understanding clients and the challenges they face can help ensure an ESOP is implemented correctly.
From our work with this section of the market, it is clear they have two key themes:
- Financial harvest: A focus on cashing in and extracting maximum value from the business after years of blood, sweat and tears; and
- Stewardship/legacy: A focus on preserving the legacy of the owners and looking after crucial stakeholders, including employees, clients and suppliers.
Most exit strategies fit into one of these two themes. However, an ESOP can provide the best aspects of both: a combination of financial harvest (selling the equity at a reasonable price) and stewardship by enabling the key people to buy the business and continue the culture, style and character of the company. They also have the significant benefit of being a more gradual, controlled and documented exit allowing a smooth handover of control, upskilling of key people to run the business and more time to finance the transition.
Investing time to develop an ESOP is one of the most important financial decisions a business owner will ever make, because without one the value in the business will retire as soon as they do. If designed correctly and integrated well into the corporate governance and employee engagement programs, an ESOP will ensure that business owners are excellently placed to navigate what can be a challenging time fraught with uncertainty.
When accompanied by a strong education and upskilling program, ESOPs can indeed be a win for all involved.
ESOPs are increasingly being sought by business owners who want to gain immediate term productivity and engagement benefits while providing longer-term stability for their business. They can be an innovative way to gain productivity and retention benefits and a key succession planning tool.
Exploring the benefits of ESOPs with clients who own a business may be an excellent tool for maximising the value of that business and ensuring a successful transition into retirement when they are ready.
Craig West is founder of Succession Plus.