Option Scheme Design II
Overview
Most employee share schemes fall into three categories; profit-sharing schemes, savings-related schemes, and executives share option schemes. Tax breaks are central to employee share schemes.
Most schemes are tailored around reliefs made available by tax legislation. The legislation is part of a state policy of encouraging employee participation in the economic success of the employer.
Share option schemes are used most commonly by listed companies. Listed companies have a ready market and liquid market for their shares.
Share option schemes, in common with the other employee share schemes seek to incentivise the employee to maximise the value of the business. It seeks to align the interest of the shareholders with those of senior management or employees, as the case may be.
Options for Senior Executives
The most common type of shares scheme for senior executives, are executive share option scheme. The company grants rights to executives to buy shares, which are exercisable at periods, generally 3 to 10 years after the grant, provided that executive remains in employment.
The option is usually one to buy for a fixed price. Accordingly, if the share price increases in value, the executive / employee will benefit. If it does not increase in value, the option will not be exercised.
Some companies facilitate their senior executive and / or other employees in financing purchase of shares. They will not directly assist in purchase ,but provide financial arrangements with the brokers or others, in order to facilitate the exercise of share options.
A scheme may provide for a single exercise price and a period of exercise. However, there may be varying terms, prices and option periods. For example, an option may be exercisable at its issue market price after three years and at a lower alternative price if defined performance targets are achieved.
Restricted and Phantom for Executives
Restricted share schemes originated in the United States. Free shares are allotted to executives and employees but are forfeited if they leave employment within a certain period or if performance targets are not achieved.
The shares are held by trustees during this period.A variation may involve the employee purchasing shares, possibly by use of cash bonuses, with further or matching additional free shares.
A phantom share scheme may be operated by a subsidiary of a stock exchange-quoted company. The subsidiary will not be in a position to issue shares in itself. A cash bonus may be promised that follows the movements in the share price of a holding company.
Share Option Schemes
Some companies establish savings-related share option schemes. These schemes give employees the opportunity to save and participate in share options. They are usually for the benefit of all or most (qualifying) employees. The options are granted in tandem with the savings-related schemes for the purchase of shares at a discount from the market value at the date of grant.
Some free shares may be issued under the profit-sharing scheme. Another structure may involve matching offers of free shares, with the shares acquired under the savings or other arrangements.
Some companies, generally private companies, allow employees to purchase or subscribe for shares in the company. The Articles of Association may provide that the shares are offered to an employee share trust. They may be then offered by the trustees to employees at regular intervals.
Schemes commonly have a ten year duration. Commonly, schemes provide for issue up to 10% of the share capital of the company over a period of years. A flow rate of 3% per annum over a period of three years is commonly encountered. There may be a slower rates, such as 1% per annum over 10 years.
Workforce Wide
There may be overall employee share schemes, which also incorporate executive options as a percentage of the total.
Schemes are generally open to directors and employees who devote substantially the whole of their working time to the business of the employer. They may be issued to part-timers, on less favourable terms or may not be available to part time employees.
There are usually limits on the maximum participation by executives linked to annual emoluments. There may be a variation from this position in exceptional circumstances.
Options must be granted by listed companies at not less than the middle market price at the time the option is granted. Approved savings-related share options may be granted for not less than 80% of the market value of the class of shares so granted.
Exercise of Option
Share options periods are generally within a certain period, commonly 30 to 50 days, of the publication of periodic financial results. The appropriation of profits under profit-sharing schemes are usually made after the publication of annual results for the trading period, for which the appropriation is made.
Executive options schemes may make provision for early exercise, where a person dies or ceases to be employed, without distinction between good and bad leaver. It should be exercised within one year of leaving.
Options may allow the right to be exercised by early leavers until up to three and half years from the grant of the latest option.
Listing & Company Law Issues
Listing rules constrain the conditions under which share options are issued by quoted companies. Listing rules grant exemptions from general requirements, in order to facilitate the issue of shares an share option right under employee share schemes.
Company law allows for the issue of shares by way of employee share schemes. It allows for assistance which would not otherwise be permissible in respect of acquisition of shares of the company.
Company law provides for restrictions on allotments and pre-emption, which are discussed in other sections. These provisions are not applicable to securities under employee share schemes.
There are exemptions from the general prohibition on financial assistance for the purchase of shares under the employee share scheme. The financial assistance or benefit might, for example, comprise interest-free loans.
Companies commonly provide in their Memorandum and Articles, a power to establish a scheme. This may incorporate a power to lend to individuals or trustees to enable them to acquire shares. In the absence of such clause, it may be possible to establish a scheme based on general powers. The Companies Act, will remove the requirement for objects and powers for most companies after 1st December 2016.
The Companies Act restricts public companies from allotting shares at discounts. The shares must not be issued at less than the nominal value. They may, however, be issued at discounts to the market value. Listed companies must work within the parameters of the listing rules in respect of share options.
Employee Share Schemes
Employee share schemes may require the approval of the company shareholders in a general meeting. The listing rules provide for matters which must be set out in the circular to shareholders. In particular, the listing rules provide for
- the parties who may be eligible;
- the maximum number of shares available;
- the maximum individual entitlement;
- voting, dividend, transfer and other rights, including those on liquidation; and
- the amounts, if any, payable on acceptance and the basis for determining the option price.
Approval must also be obtained for most substance amendments.
Revenue approval is required to obtain a favourable taxation treatment for share schemes. See the separate sections in relation to the tax status of employee share schemes. Revenue will require certain information, including in particular
- resolutions adopting the schemes;
- scheme documents;
- materials to be issued to employees;
- shareholder circulars, if any and
- other prescribed information.
Terms of Schemes
Financial bodies’ recommendations have been influential in setting the parameters in relation to key terms, such as the time limits for exercise and the percentage of shares that may be offered in the scheme.
There are stock exchange rules on the duration of share option schemes. Institutional guidelines recommend that schemes should be no more than 10 years in duration. The cost of establishment of the scheme are generally tax-deductible.
If approval is withdrawn, the tax benefits are withdrawn. This may also occur if the scheme contravenes approval requirements, the participant breaches undertakings or if trustees fail to furnish required information.
Restricted Persons
Persons with a material interest in a company are restricted from obtaining shares through the share option scheme. The restriction applies to “participators” in close companies.
Generally, see the section on close companies in relation to the classes of persons who are defined as participators. A material interest is 25% of the share capital in the case of an approved profit-sharing or savings-related scheme or more than 10% in the case of an approved share option scheme.
Value
The market value of shares is determined in accordance with the capital gains tax rules. The market value of the quoted shares is generally based on the listed.
The market value for unquoted shares is the open market value, on the assumption that a prospective purchaser has all the information which a prudent prospective purchaser may reasonably require in purchasing the shares. The criteria applicable under CGT legislation in relation to the value of private company shares are, in broad terms, applicable.