Equity incentives are a component of an employee’s overall compensation package that gives employees a route to owning a portion of the company they work for. The two main types of equity incentives are shares and options. Shares represent direct ownership in the company, whereas options give employees the right to purchase shares at a later date.
This post is the first in a 3-part series in which we will help you determine which type of equity incentive plan is the right fit for your business. In this post, we review the reasons for offering equity incentives and the main types of share incentive structures available in the UK.
There are three main reasons to offer equity incentives:
Equity incentives have unique advantages over other types of compensation because they give recipients interest in the long-term success of the company. By doing so, equity incentives align the goals of the recipient with the goals of the shareholders, directors and management of the company.
Equity incentives help attract and retain talent by making a compensation package more attractive, both in terms of increasing the overall potential for financial gain and by demonstrating the company’s willingness to invest in a long-term relationship. Studies have also shown that employees with equity incentives perform better by making them more productive, increasing engagement and making them feel valued.
Finally, as a non-cash incentive, equity incentives benefit companies by allowing them to add value to an overall compensation package without impacting short-term cash flow.
To understand the differences between the types of equity incentives available in the UK, it’s important to first understand the difference between approved and unapproved schemes.
There are five main types of share incentives available in the UK:
Share vesting plans are unapproved share incentive schemes under which participants receive shares over time based on a vesting schedule. Vesting schedules generally provide for an initial “cliff period” during which the participant does not receive any shares, followed by a multi-year schedule where the participant receives a portion of their overall share award on a monthly, quarterly or annual basis. Share vesting plans are discretionary share schemes that can be offered to some or all employees (or non-employees like consultants, advisors and non-executive directors), and can be offered to different participants on different terms.
Growth share plans are unapproved share incentive schemes under which participants receive a special class of shares. Growth shares reward participants for the growth in value of the company above an established “hurdle”, meaning that the participants begin to benefit once the company reaches a certain valuation. Like share vesting plans, growth share plans can be offered on a discretionary basis to employees and non-employees alike and can be offered to different participants on different terms.
Restricted Stock Unit plans (RSUs) are unapproved share incentive schemes under which participants are granted the right to receive a certain number of shares (or a cash payment equal to the value of a certain number of shares) in the future. Because participants do not receive the shares themselves upfront, participants are not entitled to any shareholder rights (like voting and dividends) until the date they receive the shares. RSUs can be offered on a discretionary basis and on terms that vary from participant to participant.
Share Incentive Plans (SIPs) are share incentive schemes under which the shares offered to employees are held in a specially-established trust. Because the shares are placed in a trust, participants are the beneficial owners of SIP shares. This means individual participants receive the financial benefit of their shares with one or more trustees managing all shares under the plan.
There are four types of shares that can be awarded to an employee under a SIP:
SIPs were once approved share schemes, requiring an application to and approval by HMRC before establishing the SIP. Today, while a company must still notify HMRC of the establishment of a SIP, no approval is required. However, companies with SIPs must submit an annual self-certification to HMRC, stating that the SIP meets the certain requirements:
A. Non-Discretionary. SIPs are non-discretionary share schemes, meaning that participation must be offered to all employees who reside in the UK.
B. Qualifying Service Period. Companies may impose a qualifying service period for participation in the SIP, meaning that employees must be employed by the company for a minimum period of time to be eligible to participate. However, the qualifying service period cannot exceed 18 months.
C. Share Conditions. Shares offered through a SIP must be fully paid-up, non-redeemable, ordinary shares.
D. Company Conditions. Companies are eligible to establish a SIP only if one of the following applies:
E. Trustee Conditions. The governing documents of the SIP must require the trustee to:
Phantom share plans – also referred to as “ghost shares” or “shadow shares” – are deferred compensation plans that offer employees one or more cash bonuses, with the value of the bonus tied to the value of the company’s shares. Although the structure of a phantom share plan differs from company to company, cash bonuses are typically either issued on a predetermined date or when a “trigger event” occurs (such as an increased valuation or an exit).
Phantom share plans are often attractive to companies who wish to incentivize their employees to improve the overall value of the company but do not wish to issue employees equity in any form (including both shares and options).
Equity incentives are a valuable component of a compensation package that helps attract and retain talent, promoting the company’s long-term success without short-term impacts on cash flow. There are a number of equity incentive structures available in the UK, including approved and unapproved share incentive plans and option plans. It is important to understand the differences between how each type of equity incentive operates, including advantages and disadvantages, in order to determine which type of equity incentive plan is best suited for your company.
In the next post in this series, we will review the main types of option plans available in the UK.
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Our legal commentary is not intended to be a comprehensive review of all developments in the law and practice. Please seek legal advice before applying it to specific issues or transactions.
