At a recent event we hosted for founder/owners looking to sell their business, the topic of Employee Equity came up, which proved to be a highly divisive topic. At Morphose, we support businesses at every stage with funding rounds and exits, and we thought it worthwhile taking a closer look to understand the reason for such strong opinions on whether to reward employees with equity or not.
There are various mechanisms to transfer shares to employees which we’ll touch on briefly below. However, the main purpose of this article is to explore the principle itself of giving equity to employees, and some of the key considerations in doing so.
At our event, Scaling for Exit, the debate around transferring shares to employees generally fell into two main camps. On one side, there were those who fundamentally disagreed with the concept of giving away equity to employees, particularly in the early stages of a business. These business owners, quite often seasoned entrepreneurs, argued that handing out equity to early employees can lead to complications when those employees are potentially less involved or pivotal in the business during its later, more profitable stages. The premise being that as a business grows and evolves, new skills are often required in senior roles, and there is a risk that early stage employees won’t evolve with the business. From their perspective, every bit of equity is precious and should not be given away unless it offers clear long-term value.
There was also among this camp, dare we say it, a degree of hardened cynicism around the commitment of employees and an appreciation that they could take flight presented with a better offer, posing a greater risk if they’re also shareholders. And longer term, messy cap tables with multiple minority shareholders can bring added complications when it comes to the sale of a business and serious exit discussions.
On the other side were those business owners who viewed employee equity as a powerful way to reward, incentivise and retain employees. For smaller businesses competing against large companies with higher salaries and more attractive benefit packages, offering equity and a stake in the business can be an effective way to attract and keep key employees engaged and invested in the company's success. Some business owners in this camp shared success stories where expectations had been achieved, with long-term employees who stepped up into management roles taking on responsibilities well beyond their salary package.
One of the most effective ways to achieve this alignment is through EMI (Enterprise Management Incentive) and Share Option schemes. When set up properly, these schemes are not only an effective way to incentivise employees but also offer a tax-efficient mechanism. A key advantage is that they can allow businesses to retain equity control until the shares have vested, providing downside protection as employees who leave before vesting lose their options.
Growth Shares present another viable option. These are a different class of shares from “Ordinary” shares and can therefore have different rights. They often include a vesting period, aligning employees with the future success of the business rather than rewarding them for past performance. Sometimes referred to as “alphabet” shares, Growth Shares can also be tax effective for recipients, as their limited initial value often results in them being issued at a deep discount.
Deciding whether to reward employees with equity involves carefully considering the type of share scheme to offer and determining whether the category shares will carry voting or dividend rights. Dividend-bearing shares enable employees to benefit from the business’s success on an annual basis, while shares with voting rights allow employees to influence the company’s direction and decisions such as profit allocation for dividends each year.
We found that seasoned entrepreneurs, often hardened by boardroom battles, were more reluctant to grant employees voting rights. However, issuing different categories of shares can sometimes create confusion among employees, leading to misunderstandings about what was being gifted and how to realise monetary value from it. This sometimes resulted in unrealistic expectations, as employees were unclear about whether their shares were dividend-bearing, causing tension when they discovered otherwise. There were also challenging conversations about the timing of a company’s sale.
It’s important that equity, EMIs, Share Options, or any long-term incentive mechanism should only ever be used if (1) the recipient understands and appreciates what they offer, and (2) they align with the issuer’s medium/long-term plans. There’s little benefit in issuing Share Options to staff if you plan to sell in less than a year and the Options don’t have an accelerated vesting clause triggered by such an event. The last thing you want is disgruntled employees feeling cheated or used.
Another key point when considering employee equity is what happens when an employee/shareholder leaves the business, since the last thing you want is a disgruntled former employee to retain shares or voting rights, with the potential to disrupt the company's direction. This is particularly relevant to growth shares or options with defined vesting periods, so ensure provisions are in place to protect against "bad leavers" or potentially any leavers.
Lastly, the ultimate employee equity scheme is an EOT (Employee Ownership Trust), which over time transfers at least the majority of the equity from the current owners to an employee trust. This structure can save the sellers all tax on the transaction, but it isn’t for every business. Success typically depends on a strong management team and a profitable business that can provide sellers with at least a reasonable portion of the agreed price at completion. We have worked with a number of companies setting up EOTs, and they have proved very effective for owner/founders who are content to benefit from a gradual release of equity from their business, while ensuring business continuity and a higher degree of job security for employees than some other exit mechanisms.
Ultimately, rewarding high-performing employees with equity requires serious consideration as well as robust legal and tax advice. However, done right it can be a valuable way to bring in and keep top-tier employees who can really build the value of a business. On top of legal and tax advice, getting the communications to employees right is hugely important. Employees must understand exactly what they are being given and its value, the potential tax implications, whether they will be entitled to dividends, and that potential exit timelines may be affected by external factors beyond the directors or business owners' control.
Shares are often a long-term gain, but hopefully on exit are lucrative and who knows even life-changing. It’s not easy to get it right, and giving away equity to employees certainly isn’t for everyone, but the upside of committed, industrious and productive employees can really drive a business forward and generate more value in the business.
If you found this article helpful and are considering selling your business, seeking funding at any stage, or exploring employee reward schemes, we’d love to connect. Feel free to reach out to us at Morphose, we’re here to help!
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