Think twice about employee shares.....

_{Article written by Sue Prestney for 'Charter', the magazine of the Australian Chartered Accountant
Sue Prestney is a Senior Partner with MGI Melboune.
Article reprinted with the permission of the Institute of Chartered Accountants in Australia, www.icaa.com.au} 

Last month I wrote about the tax issues that arise when an SME owner wishes to issue or transfer shares to an employee for less than market value.

That discussion was predicated on the basis that such a strategy is in the best interests of the business – to facilitate succession and/or retain key skills and experience.  However, in many instances, the motivation behind employee shareholdings is more enigmatic.

When SME owners raise the subject of providing shares to employees they often find it to difficult to explain whether it is a reward for past service or motivation to work hard in the future to grow the value of the business.

Many SME owners want to share their success with the people who have contributed to it, and that is a noble sentiment.  However there are other ways of doing this that don’t involve taking on business partners such as bonuses, non-cash benefits and phantom equity arrangements that include sharing in capital proceeds of a sale.

All too often we have to deal with situations where generous SME owners find themselves with greedy, ungrateful employee shareholders who take their good fortune as their due and seek to milk their position for all it is worth.  Which wouldn’t be too bad if they were making valuable contributions to the business – unfortunately this isn’t always the case.

Serious consideration needs to be given to the potential consequences of giving equity to employees:-

Behavioural problems often arise from employees being elevated to ownership level and feeling superior to other employees (despite the fact that the shareholdings are usually very minor and carry no real decision making power).

Having other shareholders raises issues of shareholders’ rights and, while minority shareholders don’t have many rights, they are entitled to receive annual financial reports (in the case of small proprietary companies, shareholders with at least 5% of the votes may require reports and may also require them to be audited).  The Corporations Act also provides protection against oppression of minority shareholders which SME owners need to consider when they are going about their usual practice of operating the company in their own interests; for example where the directors decide not to pay dividends but at the same time increase their own wages, or cannot produce a good business reason for refusing dividends.

Employee shareholders may not necessarily have the same attitude as the majority shareholders when it comes to the payment of dividends (compared to accumulating wealth in the business); the exit strategy for the owners; the employment of members of the owner’s family; the borrowing of money by the owner from the company and a myriad of issues.  While practically, they cannot influence such decisions, because they are shareholders they often feel they have a right to express an opinion which they wouldn’t feel if they were simply employees.

While much of the potential for conflict can be dealt with through a shareholders agreement, the mere preparation of such an agreement can actually create tension just through discussing the relevant issues.  Because of this, or because of the cost of preparation, many SME owners put the employee shareholdings in place without shareholders agreements and don’t even address the vital issues of when shares must be sold and at what value.

Valuation is an issue that drags many business people to court.  Disgruntled ex-employees tend to have an exaggerated view of the value of the shares they have been required to part with and many lawyers have been able to meet the payments on their BMWs from the fees of SME owners who dispute that value.

It’s so important for business owners to consider all the issues involved in providing equity to their employees before they give in to ‘feel good’ motivations.  Giving shares to employees can be the business equivalent of a hot fudge sundae – tastes sweet at the time but may ultimately result in central chest pain.

Ultimately employee share arrangements need to be in the best interests of the business.  If providing shares to employees retains skills that are essential to the future strategy for the business, or motivates them to build the value of the business, then it may indeed make sound business sense.

But first you should consider whether that retention of skills or motivation to achieve growth can be obtained by other means, such as phantom equity plans.  Providing real equity in a private company in my view is something that should only be offered in a very focussed way, such as a means of securing a succession plan for the business.  If equity is to be provided to employees, the rules for the equity arrangement must be clearly documented, be consistent with the objectives of the arrangement and ensure that the possibilities for conflict are minimised.

Providing equity in your business can ultimately cost a great deal, not only in terms of the value you may relinquish, but in the time and stress (and possibility tax) that inevitably result from flawed arrangements.  Indeed, the cost of unravelling an employee share arrangement is likely to outweigh the cost of proper implementation.  Not consulting advisors for such a vital step is the falsest of false economies.

MGI Melbourne is a member of MGI Australasia

http://www.mgiaust.com/

www.mgimelb.com.au

2009-12-08