Employee incentivisation often goes further than the remuneration paid by an employer to its employees for job performance. It aims to assist employers in retaining their key employees by creating incentivisation for employees to remain committed to the employer and build and grow the company and for the employee to participate in that growth. Employee incentivisation schemes are a valuable tool that employers can use to retain their employees and reward them in the long run.
There are different versions of employee incentivisation schemes, and the two that we see most often being used are a direct employee share ownership plan (ESOP) and a phantom share scheme. Very briefly, a direct ESOP awards actual shares of the company to employees (meaning that the employees become shareholders) and a phantom scheme is effectively a cash bonus scheme where the employee’s bonus is linked to and based on the value of the company and what the employee would have received if he/she were a shareholder.
Key features of an ESOP and phantom share scheme:
| ESOP | Phantom Scheme |
| Employees usually hold actual shares in the company and are shareholders | Notional shares are issued to employees – they are not real shares but are linked to the real shares of the company |
| Employee shareholders are reflected on the company’s cap table / share register | A separate participation register is maintained – participants aren’t recorded on the cap table |
| The ESOP rules are adopted as part of the MOI and may require shareholder approval | The phantom share scheme rules are usually adopted by the board as a company policy |
| Voting rights of ESOP shareholders are usually limited (by creating a separate class of shares for the ESOP shares) | Participants do not have any voting rights at shareholder level as they are not shareholders |
| The ESOP shares will be subject to the shareholders’ agreement of the company, the memorandum of incorporation, the ESOP rules and participation agreement | Phantom shares are not subject to the shareholders’ agreement, but will be subject to the scheme rules and participation agreement |
| ESOP shares will generally be restricted equity instruments in terms of the Income Tax Act | The value received from the phantom shares (the cash bonus) will be taxable as income as it is received as a result of employment |
Key concepts applicable to employee incentivisation schemes:
- Vesting provisions
- Although the employee is the owner of the shares, the economic benefit to the shares is delayed and must be earned over a period of time, which is referred to as the “vesting” period. Both ESOP shares and phantom shares can be subject to vesting provisions.
- An example to illustrate: shares will vest over a 4 year period, with 25% of the shares vesting at the end of the first year, and the remaining 75% vesting monthly over the following 3 years. This means that 25% will vest 12 months after they are issued, and the remaining 75% will vest monthly over 36 months. Therefore, at the end of 2 years, 50% of the shares will have vested and the employee will be entitled to the economic benefit of 50% of his shares (subject of course to the terms of the incentivisation scheme).
- For the tax buffs out there, here, vesting refers to the right to the economic benefit of the shares and not the typical tax ‘vesting’ in section 8C when the share ‘vests’ once the restrictions on that share are lifted – this ‘vesting’ is discussed in the next point on restrictions.
- Restriction of the share
- If shares are restricted, they are not free to be dealt with by the employee until the shares become unrestricted. The employee therefore cannot sell the shares to other shareholders or third parties and the shares cannot be encumbered (used as security) until they have become unrestricted – even after the shares may have vested as referred to under point 1 (i.e. after the 4 year period has passed).
- The restriction of the shares is important for 3 reasons:
(1) the restriction postpones the tax liability that the employee will experience until the employee disposes of the shares and receives cash to pay that tax liability;
(2) in line with the first reason, the restriction serves to avoid the employee being required to pay income tax on the gain experienced on the shares when the restrictions are lifted before the employee disposes of the shares; and
(3) the restriction ‘controls’ what the employee may do with the shares (i.e. preventing the employee from selling the shares or encumbering them).
Effect of termination of employment:
ESOPs and Phantom Share Schemes generally differ on this point.
- The ESOP: ESOPs generally provide that no employee may retain their shares after their employment with the company terminates. This means that the shares must be sold by the employee and are either repurchased by the company or purchased by the other shareholders of the company.
– When an employee’s employment with the company terminates, the employee will be deemed to offer all his/her shares to the company – regardless of whether the shares have vested or not. The unvested shares will be offered to the company at the same nominal price that the employee paid for the shares. The price at which the vested shares are offered to the company will be determined by whether the employee is a “good or bad leaver” (the ESOP rules will define these).
– Where the employee is a “good leaver”, the shares will be offered to the company at fair market value, and in the case of a “bad leaver”, the shares will be offered at the nominal price that was paid for the shares (or a percentage of the fair market value of the shares depending on the circumstances of the termination of employment).
- The Phantom Share Scheme. As with ESOP shares, an employee is generally required to sell their vested phantom shares to the company on termination of employment, and whether they are a good or bad leaver will determine the value at which those vested phantom shares are purchased by the company. Any unvested phantom shares of a good leaver, and all the phantom shares of a bad leaver (both vested and unvested), will lapse on termination of employment – the company does not purchase those phantom shares from the employee, and the rights attached to the shares expire.
– An alternative to the above scenario (where the vested phantom shares of a good leaver are purchased by the company) could be that all phantom shares (vested and unvested) of all employees (good and bad leavers) lapse on termination of employment, and that phantom shares only participate in the value of the company when there is a liquidity event (for example, the majority of the shareholders of the company exit and sell their shares; the company merges with an acquirer; or the company sells the majority of its assets). In this case, only participating employees who are still in the employ of the company on a liquidity event will receive a cash bonus in respect of their phantom shares (and nothing on termination of employment).
Good and bad leaver concepts
- This refers to the circumstances of the employee’s termination of employment.
- Different definitions of good and bad leavers can be applied.
- A good leaver is typically an employee that is retiring, resigning (on good terms / not to avoid being fired), has passed away, is being retrenched etc. The terms of the termination of employment are good.
- A bad leaver is where the employee’s employment is terminated, and the employee is not a good leaver. This generally includes where the termination is a result of misconduct, breach of contract, conviction of fraud or criminal offence that implicates the company, poor performance, and/or resignation on terms not mutually agreed with the company (which generally includes where the employee resigns to avoid a likely dismissal on grounds of misconduct, breach of contract and/or poor performance).
Conclusion
The terms of an ESOP and Phantom Share Scheme can be tailored to the employer’s specific requirements and the above information just sets out some of the general options that are available for an employee incentive scheme. There are of course various other structures that an employee incentivisation scheme can take (for example, an option scheme or making use of a trust), which we are happy to advise on, and the format of your scheme will need to be considered by the board and discussed with your shareholders.
Important to remember! A key point to remember when incentivising employees (whether through an ESOP, a phantom scheme or any other incentivisation method) is that any award that an employee receives as a result of their employment is likely to fall within the ambit of income in terms of the Income Tax Act and therefore be subject to personal income tax – in other words, the employee is likely going to pay income tax (PAYE) on the gain that he/she receives from that incentive. The employee will be taxed on the gain that they have experienced in respect of their shares, which is calculated as the difference between the price paid for the shares and the amount received for those shares on disposal, and the tax payable is usually income tax (PAYE) because the shares were acquired by the employee as a result of their employment.
Other versions of incentive schemes may attach different taxation obligations, however, tax in one form or another will be payable on the incentive that the employee receives.
