What is an ESOP?
An ESOP plays a paramount role here as it transforms team members into stakeholders by allowing employees to own shares in the business they work for. This ensures that their interests run parallel with those of the business owner, and subsequently boosts productivity by instilling a profound sense of responsibility. When employees have a vested interest in the company’s success, they will be more motivated in attaining long-term goals. Through the new lens of ownership, employees can perceive the direct impact of their day-to-day decisions and behaviors are tied directly to the company’s growth.
The structure of an ESOP can vary significantly, with some employees opting to purchase shares outright and others earning them through tenure or performance. In some cases, shares might be gifted under specific tax concessions. Nonetheless, the end goal remains the same across ESOPs: aligning the growth of the company with the personal and financial aspirations of its employees.
Why Consider an ESOP?
Employee Engagement and Retention
An engaged workforce is a productive workforce. When employees feel invested in the mission of the business – both emotionally and financially – they’re more likely to stay. ESOPs create a tangible connection between employees’ efforts and the company’s growth. If profits increase, employees benefit not only from their salaries but also through dividends or increased share value, creating a cycle of productivity-driven growth.
Aside from maintaining employee engagement, ESOPs can also act as financial incentives to encourage longevity and assist with employee retention. Shares that vest over extended periods of time compel employees to remain with the company for longer, whilst reverse vesting discourages employees from leaving early to prevent their shares from reverting to the company at a lower value.
Attract Top Talent
In industries where competition is fierce, the gleaming promise of equity stands out.
According to the 2022 Tech & the Law report published by Thomson Reuters, the third largest focus in 2023 for private practice firms will be attracting, retaining or upskilling talent, with just under half of all firms expressing their priorities in that way.
A job advertisement promising not just a salary but a stake in the company’s future is attractive. ESOPs demonstrate that the company values its employees’ contributions and is willing to share its success.
Customer loyalty
Beyond the internal benefits, ESOPs can influence how businesses are perceived externally. Customers tend to support employee-owned businesses as they value the commitment and care often associated with companies that propound employee ownership. Some customers are even willing to pay a premium for products or services from employee-owned businesses as they know they will receive better customer service, quality and care.
Business Performance and Culture
Ownership fosters accountability. Employees who own shares are more likely to think and act like business owners and take into consideration factors like profitability, customer satisfaction, and efficiency in their decisions. This mindset shift can lead to improved performance across the board. To reinforce this, Craig raises an example where an ESOP led to improved workplace safety within a mining services company. By tying share allocation to safety metrics, employees took proactive steps to minimise incidents and the hours lost due to safety issues.
If constructed properly, ESOPs can bring companies tax advantages such as the startup tax concession or deferred tax plan. These concessions reduce financial burdens for employees and make ESOPs an attractive tool for startups and small-to-medium enterprises to align employee interests with company growth.
The Australian Tax Office promotes two key tax concession schemes:
- The ESS Startup Rules: Introduced in 2015, this allows eligible businesses (with turnover under $50 million and operating for less than 10 years) to offer shares to employees without any upfront tax. Employees are only taxed on capital gains when they sell their shares, which is typically more favorable than income tax.
- The Deferred Tax Plans: Division 83A of the Income Tax Assessment Act 1997 enables employees to defer taxation for up to 15 years or until certain conditions are met, such as leaving the company or selling their shares.
Creating an ESOP tailored to your business involves several key steps:
1. Assess, Review, Evaluate
- Get a valuation of your business. You will need an estimate of how much your business is worth in order to determine the market value of your shares.
- Understand what your business structure looks like. Who owns the shares? Is it in a trust? Is it in a company? Does the structure actually suit the employee share plan rules?
- Assess what you hope to achieve with an ESOP. Whether it’s improving retention, driving performance, or creating a succession plan, your objectives will shape the structure and rules of the ESOP.
2. Design the Structure
ESOPs come in various forms:
- Gifted Shares, where employees receive shares as part of their compensation package. Under certain tax concessions, this can be done tax-free up to specific limits.
- Profit Sharing, where employees earn shares through a portion of company profits. This method aligns financial incentives with company performance.
- Salary Sacrifice, where employees allocate a portion of their salary to purchase shares at a favorable rate.
- Direct Purchase, where employees buy shares outright, often at a discounted or fair market value.
Succession Plus has a wealth of great resources available, including a guide covering all things ESS related to help you decide whether it may apply or be relevant to you. You can also download Craig’s book on employee ownership for free here, or reach out to the Hearsay team for a physical copy to be emailed to you.
3. Put it in writing
The ESOP plan rules define the foundational framework of the program. These rules should cover:
- The requirements around eligibility of ESOP participants. This may include tenure, role, or employee performance,
- The allocation of shares,
- The vesting period of shares, or when employees will gain full ownership of their shares,
- Exit clauses to provide clarity on what happens if employees leave, retire, or are terminated,
- Bad leaver clauses to disqualify employees leaving for a competitor from share ownership,
- If applicable, restrictions on how employees can sell or transfer shares.
When creating an ESOP, it is critical that a qualified lawyer is consulted throughout the process. Legal expertise ensures that the plan is legally compliant and structured in a way that meets both company and employee needs.
4. Educate & Engage your Employees
Your employees need to understand their rights and obligations under your ESOP plan. A simplified, plain-English version of the legal documents to explain the plan is necessary to ensure that they are aware of what ownership entails, how their shares are valued, the benefits they’ll receive and the processes for exiting or selling shares.
To ensure their vested interest in the company stays top of mind, you must consistently inform your employees on the value of their shares, company performance, and any dividends they are earning. Craig suggests a mobile app with push notifications that notify employees on dividend payouts and company valuations. With an accessible app that allows users to stay on top of their shareholdings, employees are able to see visual reminders of how they can benefit from the ESOP and remain motivated to contribute to the company’s success.
5. Managing your ESOP
Managing an ESOP involves regular valuation and compliance with legal and tax obligations.
Annual valuations of the company are critical for tracking performance and determining share values, but they also provide insights into how the business can increase its value. Craig highlights how addressing high-risk areas or reducing dependency on key individuals within the company can enhance overall performance and, in turn, boost the value of employee shares.
Compliance is a foundational aspect of ESOP management. Employers must prepare and file ESS tax statements annually. These statements, similar to old group certificates, outline employee earnings from the share plan and need to be distributed to employees by mid-July to assist with their tax returns. Key information such as share acquisition dates, market value, and discounts on interests must also be reported. For the ATO, electronic submission of annual employee incentive scheme reports is required by August 14 each year, detailing plan identifiers, acquisition dates, and amounts withheld from discounts.
Final Thoughts
Democratising ownership through ESOPs is more than a financial strategy; it’s a cultural shift. By empowering employees with a stake in the company’s success, businesses can unlock unparalleled levels of engagement, performance, and loyalty. Whether your goal is succession planning, improving retention, or driving specific metrics, an ESOP might be the key to aligning everyone under one shared vision – the growth and success of your business.
Curious to learn more? Dive deeper into ESOPs by tuning into the CPD episode on Hearsay the Legal Podcast, where Craig unpacks the practicalities of implementing ESOPs and their transformative impact on businesses.
Listen here to learn more.
***This blog was originally published on Hearsay the Legal Podcast.
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