Employee Incentive Plans – which plan should you adopt?

What are employee incentive plans and why do employers use them?

Very generally, employee incentive plans provide employees with equity in their employer.  In theory, this should lead to a closer alignment between the interests of employers and employees, which in turn should lead to greater productivity.

An employee incentive plan can also act as a retention tool.  This is because an employee’s rights under the plan are usually tied to continued service or service for a minimum period.

An employee incentive plan can also provide an employee with another form of remuneration which, in some cases, may be tax effective for the employee, and from a commercial perspective, allows the employer to reduce the upfront cash spend on remuneration.

What are the most common types of employee incentive plans?

The forms of employee incentive plans vary greatly.  The design of a plan will be largely driven by the size and stage of growth of the employer and the employer’s needs and goals.  The most common types of employee incentive plans are share option plans, share rights plans (such as performance rights plans), share plans with some form of deferral period or other restrictions, and phantom plans.

Share Option Plans

An option provides the employee with a right to acquire a share at some point in the future subject to paying an exercise price.  Options generally have vesting conditions which must be satisfied before an option can be exercised.  If the vesting conditions are not achieved, the option lapses.

Vesting conditions may be based on time or may be based on the achievement of certain milestones or performance criteria.

Options are a separate security to a share and, therefore, carry no rights as a shareholder until the options are exercised and the shares are acquired.

For the employee, the value of an exercised option depends on the difference between the exercise price and the price of the shares at exercise.  In a falling market where there is a decline in the share price such that the exercise price is higher than the current share price, then the options will have no value to the employee and will not be an effective incentive or retention tool.

Share option plans are reasonably popular in Australia and are used across the market from small start-ups to larger listed companies, as well as across different industry sectors - though with a particular prevalence in the mining, energy, healthcare, and the technology sectors.  Options are less common as long-term incentives for senior executives of large ASX-listed companies, with the preference being the issue of performance rights.

Performance Right Plans

A performance right is contingent right to acquire a share in the future but with no exercise price, rather the shares are provided for nil consideration once the vesting conditions are achieved.  Like options, vesting can be dependent on time, milestones or performance criteria.  If the vesting conditions are not achieved, the performance rights lapse.  If a performance right vests, the value for the employee is the price of the share at vesting.  So performance rights, once vested, always have some value even in a falling market.

Performance Rights Plans are the most prevalent plan type for senior executives of ASX-listed companies.  A majority of the top 100 ASX-listed companies use performance rights for their executives with a total shareholder return (TSR) performance measure which can be relative to a defined peer group, or an absolute hurdle.  Sometimes TSR is combined with a second measure such as earnings per share.  Unlisted companies also use performance rights.  Performance measures for such companies also tend to be financial with revenue and EBITDA targets commonly being used.

The use of financial performance metrics has to date been very much been driven by institutional shareholders and the spectre of the “two strike rule”.  With the Final Report of the Banking Royal Commission being critical of the emphasis on financial performance metrics for long-term incentives in the financial services industry, we are likely to see some limits put on financial metrics going-forward and greater weighting put on non-financial metrics.

Share Plans

A share plan at its simplest involves the issue of shares in the employer.  Share plans, however, can operate in a myriad of ways and with different permutations: (i) the shares may be fully paid or partly paid; (ii) the shares offered may be ordinary shares or another class of share; (iii) the shares may be provided for nil consideration or the acquisition of the shares may be paid for by the employee through a loan from the employer, or through deductions from the employee’s salary; and (vi) the shares may be held by the employee directly or through an employee share trust.

Generally, share plans provide the employee with the benefit of a share, including dividend and voting rights, but the shares cannot be sold for a minimum restriction or deferral period.  Forfeiture conditions may apply such that the employee forfeits his or her shares if he or she ceases employment within a specified time period.

Often shares granted under a share plan are held in an employee share trust.  Trusts have a number of advantages – they allow companies to warehouse shares for use in the plan, and given the shares are held by the trustee rather than the employee, the trust structure provides greater control over restrictions on disposal and helps with the management of any forfeiture conditions that attach to the shares.

Phantom Plans

Phantom plans do not use actual shares in the employer, but rather they involve an arrangement to reward the employee, usually with cash, on the basis of the performance of the shares or some other metric.

Which plan to adopt?

The answer to this question will depend largely on the employer’s overall objective behind adopting an employee incentive plan, as well as who will be participating in the plan.  Although not covered here, corporate law issues and tax will also be key considerations in the design and implementation of an employee incentive plan.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).