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Five key decisions before you use employee share schemes

Five key decisions before you use employee share schemes

In tech hotspots such as Silicon Valley, employee option schemes are commonly used in high-growth companies to incentivise talented people. Here is a guide to find out whether this option is right for your company, and what are areas to watch out for.

A shortage of skilled IT workers in New Zealand is commonly cited as both a barrier for growth for businesses in the technology sector and a key business challenge for IT departments.

The Ministry of Business, Innovation and Employment’s 2015 ICT Sector Report, released in May, reports a component annual growth rate for jobs in the software and IT services sector of 8.6 per cent from 2010 to 2014. More businesses in this sector (84 per cent of businesses) report vacancies, and that vacancies are hard to fill (53 per cent of businesses), than in any other sector of the economy.

While there are a number of Government and industry initiatives that have been established to address this issue, if your business is facing a hiring crunch, is there anything that you can do to attract, and retain, talent to your business?

One way to both attract and retain talent is to give employees an opportunity to participate financially in the growth of your company. In tech hotspots such as Silicon Valley, employee option schemes are commonly used in high-growth companies to incentivise talented people.

Share options give employees an option, but not an obligation, to buy shares in the company at some time in the future, at a price agreed now. When the options are exercised, employees receive the benefit of any increase in value of the shares in the company, but without having to outlay any upfront cash, or taking the risk that the value of the shares might diminish.

Recent changes in New Zealand’s legislation have made it easier for private companies to offer employee option schemes here.

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There is a tendency in New Zealand to only offer options to senior management. In Silicon Valley, participation tends to be much more widely spread.

Averill Dickson, Simmonds Stewart

If you're interested in setting up a scheme, here are five things you should consider:

1. What sort of businesses should use option schemes?

The key financial benefit for employees arises from growth in the value of the underlying shares. Option schemes therefore work best for high growth businesses. There needs to be some mechanism, in the future, for the employee to realise that value. If an employee exercises her options, but can’t then sell the resulting shares, the only financial benefit is a possible ongoing dividend stream. Employee option schemes are therefore less useful in businesses where there is no intention for the majority owner(s) to exit, (for example, closely held, long term family businesses).

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2. Which employees should I offer options to?

There is a tendency in New Zealand to only offer options to senior management. In Silicon Valley, participation tends to be much more widely spread, with it being common for early-stage companies to assume they'll be giving up 10 to 15 per cent of their shares in options.

My view is that businesses should consider offering participation to any talented employee that can help the company grow, and where participation will help to attract, incentivise, retain and reward that employee. If an employee is unlikely to have any effect on the growth of the company, or is unlikely to be incentivised from participation in the scheme, leave them out. Conversely, don’t leave out a star employee just because they aren’t in a management role. Be aware, though, that picking and choosing employees in this way can be divisive and lead to employees not selected for the scheme being demotivated.

3. What price?

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Options are issued with an exercise price – being the price that the employee must pay to acquire a share if and when he exercises an option. Generally this is set to reflect the value of the company at the time that the option is issued, so that the employee benefits from the growth after that date. You therefore need to work out a realistic valuation for your company now. Don’t set the price too high - a so-called “underwater” option (where the value of the underlying share is less than the exercise price) provides very little in the way of incentive to employees.

4. What if my employees leave?

In order to not only attract staff, but also to retain them, you need to design the rules so that staff have to stay for a certain period of time before they can exercise their rights to buy shares. This is called “vesting”. Some schemes vest in tranches over time (for example, 1/3rd per year), others vest in one hit after a certain period of employment. Most schemes also provide for early vesting if some form of exit event takes place (for example, a sale or IPO of the company).

Also, if people leave, say after three years, there's usually a period of time under which they have to exercise their rights. Generally you don't want lots of former employees out there who still have options to buy shares in the company.

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5. What sort of shares should I offer?

Option schemes can be structured so that employees that exercise their options receive non-voting shares in the company. The rationale for doing this is to provide the financial benefit of share value growth to employees but without making the majority owner(s) subject to employees (and possible ex-employees) having a say in the running of the business. However, in doing so, you are saying to your employees that you don’t value their opinions.

You are also removing one of the key non-financial benefits of an option scheme – giving your employees a sense of ownership in the growth and success of your business. For these reasons, we favour granting options over voting shares.

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Averill Dickson is a senior lawyer at Simmonds Stewart, a boutique technology law firm providing corporate and commercial legal services focused on the New Zealand technology sector. With almost 20 years in the technology sector, Averill has extensive experience advising on the corporate and commercial aspects of technology businesses and transactions. Find out more at Simmonds Stewart, or follow Averill on Twitter @averilldickson. Simmonds Stewart has free online templates for tech companies, and a blog on IT legal issues.

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Tags skills shortagestaff retentionagilestaff managementstaffsilicon valleyglobalisationgovernment CIOlegal insightIT and the lawAverill Dickson

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