UK: Share Schemes and Incentives
James Paull, Head of the Incentives group, discusses the effect of coronavirus on incentives packages, in Taxation.
James’ article was published in Taxation, 20 October 2020, and can be found here.
The economic and social turmoil that has resulted from the response to the Covid-19 pandemic has meant that most businesses have gone through an unprecedented period of rapid change. Many businesses are unrecognisable from the start of the year; a large number are now rebuilding or adjusting their focus and business model to deal with this.
One collateral impact of this process will be on the incentives packages that are held by employees of these businesses. Arrangements implemented in recent years which were well aligned to business strategy at the time are unlikely to remain so. This gives rise to a risk of misalignment or lack of incentivisation and retention at a time when this matters more than ever.
What are the issues?
There are a number of ways in which existing incentives arrangements could have been adversely impacted by the pandemic. Below we look at some of the more commonplace:
Performance conditions are no longer appropriate
When awards were made, it is likely that the financial projections and business strategy on which the performance targets were based were vastly different to those now in existence. It may well be that those targets are now perceived to be unachievable. Likewise, they could incentivise behaviours which are not consistent with the business strategy, creating a conflict of interests for employees.
Awards are underwater
Although equity markets have bounced back well overall, there remain many incentive plans where option strike prices or performance hurdles are currently above the market value of the relevant equity. Where employees have borrowed to invest in employer equity, the loan may be higher than the value of the equity. Again, this means that the retention effect of the incentives is likely to have been eroded, in some cases permanently. In the worst cases, concerns about their financial position could distract employee focus from the job in hand.
Underwater Exits have become more remote
Many businesses will have been working towards achieving a trade sale or IPO as a means of providing a liquidity event for employee equity holders within a specific timeframe. The pandemic may have caused a rethink of these plans; at the very least these plans could have been pushed back. This is likely to lead to the perceived value of incentive awards being discounted by recipients.
Large numbers of leavers
Some businesses will have materially reduced their workforces. Where these individuals hold equity incentives, it is likely that the terms will permit the employer to repurchase the equity held by these leavers. There will often be a prescribed process and limited time frame for doing this and any repurchase will need to be funded by the employer.
Equity now in the “wrong hands”
If the business strategy has changed, it may be that some employees who were previously seen as key to delivery of the old strategy do not remain so in the new world. On the other hand, there may be others who have now become business critical who are insufficiently incentivised. There may be a need to recruit to fill key skills gaps and again these recruits will expect to be given a competitive incentive package to convince them to join.
Misalignment with new strategy
If the business strategy has materially changed then it is possible that the structure of legacy incentive arrangements is no longer optimal. For example, employees in one division may no longer perceive value in having less strongly performing divisions contributing to their incentive pay-outs.
What structures can be used to address incentives issues?
There are a number of strategies which can be adopted to address incentives issues. There is no one size fits all answer. What is best will depend on the culture of the business and the business needs in the new world. It is important to consider any changes in this light, rather than adopting a “me too” approach and seeking to follow what competitors are doing.
Broadly, the strategies can be split into two categories: refining existing incentives and implementing completely new arrangements. There are advantages and disadvantages to each, so these should be considered carefully before acting.
Refining existing awards
This could involve one or more of the following:
Modifying performance conditions
There are a number of ways this could be done, including extending the performance period, resetting earnings targets, resetting performance hurdles, using discretion to strip out estimated Covid impact and substituting an entirely new set of conditions to reflect the revised business strategy.
Where the awards are underwater, consideration could be given to adjusting the strike price to strip out any adverse consequences arising from the pandemic. Alternatively, consideration could be given to granting parallel awards which will replace the existing awards if they do not pay out, but will fall away if the original arrangements recover sufficiently.
This could be considered attractive where the equity is in the wrong hands and needs to be freed up for new awards. It may be possible to do this at relatively attractive prices in the current climate.
New or additional arrangements
The most important consideration is to ensure that the new arrangements sufficiently support the new business strategy. It is possible that arrangements that achieve tax efficiency may be available, but our recent experience is that this is now seen as a nice to have rather than a key driver. In many cases, the key consideration is to ensure that the nature and timing of tax charges is understood and that these coincide with liquidity events to avoid employees incurring a liability to tax without being able to access the funds to pay it (a so-called “dry tax charge”).
Below is a selection of the type of arrangements that could be considered:
Awards of ordinary shares
This is likely to be the simplest alternative. It could be structured as an award of shares or as an option to acquire shares in the future. In both cases this could be contingent on continued employment and/or achievement of specified performance measures. There are advantages and disadvantages to each structure and which route is best is likely to depend on the current financial position and prospects of the company, as well as the risk appetite of employees.
This is a tax favoured option arrangement, which applies to smaller companies that meet certain conditions. If these conditions are met, then this is likely to be the arrangement that achieves the optimum balance of risk and tax efficiency. For this reason, we would always recommend considering if your company will qualify.
Special classes of shares
This type of arrangement will allow you to reward employees by reference to the performance of a specific part of the business or in relation to specific aspects of the value of the business (for example growth over a hurdle). They are capable of aligning employee interests with that of the business and are potentially tax efficient. However, they do involve the employee assuming a degree of risk of loss and are complex to implement, so are not appropriate in all circumstances.
These can be a useful tool where there is pressure on cash and can be structured so that they pay out over a predefined vesting period. They can be subject to additional performance targets. Care should be taken to ensure that they are structured correctly to ensure enforceability from a legal perspective.
These should be considered where there are specific employees that are critical to the short-term welfare of the business. They are a contingent right to a cash payment if the employee stays with the business for a specified period. They are not typically subject to additional performance targets.
In our view, it is important that all businesses consider the impact that the pandemic has had on their incentive arrangements, even if the business has performed strongly. In all likelihood, employees will focus on how their incentives have fared through the crisis. In the absence of any comment from their employer, they will be likely to form their own views of the current situation and what should be done. It is to the employer’s advantage if it can take the lead on this issue.
At minimum, we would recommend that all businesses take the actions below:
- review existing incentives to assess the likely impact of the pandemic and whether the legacy arrangements remain fit for purpose;
- if change is considered necessary, consider the range of alternative steps that are available to assess which is likely to be optimal to address specific business needs. As part of this process, it is important to consider any tax, legal, accounting and regulatory issues which may arise to ensure that all consequences for the business and employees are understood;
- once the preferred path is selected, model the potential incentives outcome in a range of projected performance scenarios to ensure that an appropriate level of incentive is delivered and the business understands potential funding requirements; and
- communicate to employees the outcome of the exercise, even if the decision is to do nothing. This will demonstrate to employees that you have recognised the potential impact on incentives and acted to assess this. It may also head off many of the potential questions which will be in employees’ minds.
Those businesses that act now to consider whether any action needs to be taken and bring employees along with them are likely to be best placed to achieve maximum competitive advantage and optimise the value for money they get from their incentive arrangements.