ESOP’s and Early Growth Companies

Written by Andrew Ireland – Partner, Argyle Lawyers

ESOPs are noted as being valuable for going concern entities for a variety of reasons including assisting with:

• attracting the right personnel for the right position.

• retaining personnel.

• aligning the personnel’s objects with those of the key stakeholders.

• motivating personnel to achieve organisational performance objectives.

• recognising and rewarding personnel.

• reducing business cash outflows.

• maximising capital investment in personnel.

• sharing surplus value with personnel.

• succession planning of management and potentially stakeholders.

Indeed most studies undertaken on the subject inevitably conclude that ESOPs benefit organisations through both increased productivity and profitability.

But what about early growth companies, whose near term objectives, drivers, risk and reward structures are very different to going concern entities?

The importance of ESOPs are elevated in early growth companies and almost without exception form a critical component to the senior executive and strategic personnel’s engagement. This is typically due to the common circumstances of early growth companies, namely being pre-revenue and balance sheet constrained but with an attractive business proposition. Like all entities the early growth company must strive to attract the best skilled personnel it can, but is challenged by being unable to match the financial reward and stability that a going concern business can offer. The reality is, however, in most cases that the skilled personnel has magnified value to the early growth company as the personnel compliment is typically very small and is expected to make the right decisions at the right time.

The question is usually not whether there is an ESOP for an early growth company, rather the questions become what type of ESOP operates, what the quantum and value of the ESOP is relative to the existing equity contributed, the activation conditions of the ESOP and the balance between short term and long term incentive. The answer to these questions will influence the value considerations for both existing and future equity contributors and reflect on the board’s caliber and business acumen.

There are many types of ESOPs, each with sub-category permutations. The more usual forms of ESOPs include:

• shares issued at market value and an allied corporate loan (usually interest free).

• shares issued at a discount or on a part paid basis.

• Issuance of alternate class shares.

• share options, with or without vesting conditions and non-exercise periods.

• share trusts.

• replicator or parallel schemes.

• bonus structures.

ESOPs for going concern entities typically require careful consideration of international accounting standards and taxation issues, such as CGT and income tax, Division 7A deemed dividend provisions, fringe benefit tax and payroll tax, as well as regard to the ability to access tax exempt and deferred plans. In the main, although still very important, the significance of these considerations is somewhat reduced for early growth companies in their start-up phase, as usually they have to pass a significant value increment threshold.

ESOPs can fulfill an indispensable role for early growth companies as a means of attracting, motivating, retaining and rewarding key personnel. However, the key personnel, the company, the existing equity contributors and the future equity contributors need to be satisfied and confident that the ESOP has been correctly designed and implemented to deliver real value. All have an interest in the ESOP eventually being exercised into marketable shares or cash equivalent at some time in the future which properly reflects their investment. Otherwise, the ESOP may work against the parties’ objects.