[co-author: Erin McKirdy]

Sponsors are likely to explore share-based schemes and other plans to incentivise non-managerial staff.

Incentivising management with sweet equity and co-investment opportunities is a tried and tested strategy for buyout firms, which helps to align key management interests with those of the PE sponsor. However, PE sponsors in the US have recently been credited for extending share ownership opportunities beyond key management (and in some cases to all employees), using innovative employee incentive schemes.

Recent press coverage of impressive US payouts for “shop floor” employees and favourable firm returns underlines the positive results and publicity that can be achieved from a well-structured incentive plan. Amid the ongoing cost-of-living crisis, the “great resignation”, and increased investor focus on ESG credentials, more sponsors will likely explore share-based incentive schemes as a way to reward and retain non-managerial portfolio company staff.

Employee Share Ownership

While worker incentive schemes offer many benefits, structuring a UK scheme requires careful planning. The UK government has intermittently tried different approaches to encourage employee share ownership through various tax-efficient schemes (like EMI and CSOPs), and more recently by allowing tax breaks for business owners who divest their businesses to employees through employer share ownership trusts. These schemes are not generally suitable for PE portfolio companies — the strict qualifying criteria and certain restrictions on UK companies’ ability to buy back and recycle their own shares can make these share ownership plans difficult to administer.

What Works for Workers and Sponsors?

Expanding the employee group invited to acquire portfolio company shares at market value (subject to vesting and leaver provisions) can be an effective way to offer tax-efficient incentives. However, non-managerial employees may be unable to afford shares at market value, and there are complex tax and regulatory issues in the UK associated with implementing employee loan arrangements to address this issue. A large employee shareholder population can also add administrative costs if leavers need to be regularly processed.

Alternatively, options (which allow employees to acquire shares at a future point in time, upon payment of an agreed exercise price), can be cheaper and simpler to implement and operate compared to issuing shares to employees. Options can be granted as exercisable only at exit, and subject to automatic lapse provisions if an employee leaves. Delaying exercise of options until exit also means employees are not required to invest their own funds to acquire shares, as the exercise price can be netted off against exit proceeds. That said, options are not as tax efficient as share ownership — option gains will be subject to income tax and NICs (much like a cash bonus). In some jurisdictions (like the US) additional tax analysis is required as options typically need to be granted with an exercise price equal to market value, meaning additional valuation work is necessary and options can sometimes end up “underwater”.

Phantom Plans

Phantom share awards are becoming an increasingly popular way of incentivising staff. Such awards grant a right to receive a cash payment equal in value to the growth of a particular share class (or fraction of a share) between the date of grant and an exit. Unlike share options, the award does not confer any right to receive a share, and payment is made in cash. This arrangement can simplify the securities law analysis required to implement the plan across multiple jurisdictions, and has been adopted on recent deals. In addition, incentive arrangements geared towards an exit create alignment with shareholders, can be helpful from a cash flow perspective, and are easier to administer than issuing shares to employees, but can present the same tax issues as options or cash bonuses.

Use of Employee Benefit Trusts

Employee benefit trusts (EBTs) can also work well alongside an employee share scheme or a phantom scheme. An EBT can be used as a vehicle to acquire and warehouse management incentive plan shares from leavers and recycle for future joiners. With the right planning in place, surplus shares accumulated in an EBT can also be liquidated at exit to fund phantom scheme awards.

Beyond the Top Tier

With sponsors looking at more ways to incentivise workers beyond top-tier management, PE deal teams are likely to increasingly look at combining traditional management incentive plans for the top management tier with an adjacent scheme that tracks the value of management incentive plan shares and incentivises a wider employee population towards exit, even if that requires some additional tax costs.