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16 April 2012
How to get your employees to think and act
like owners

by Tony Brown


Encouraging employees to think and act like owners is the holy grail for all businesses. The most
effective way to achieve this is by aligning the goals and interests of key employees with those
of the owners. Sounds difficult? Not if you've considered Employee Share Ownership.

There are 3 distinct roles in every organisation: Technician, Manager and Entrepreneur. Your
reward system can provide the opportunity for employees to take on all roles.

First set out the short and long term needs and objectives for yourself, your organisation and its
employees. This article addresses only the financial components in meeting those needs. Other
needs, such as social and personal growth, are met in other ways.

General Compensation Structure
Consider a three-level compensation structure that complements these needs:
1. Base salary - the going rate for a person with the skills and experience.

2. Short-term I ncentives - team and individual performance bonuses.


Encourages focus on the achievement of business goals

Allows employees to share in profits

Rewards for meeting targets eg. quarterly payments


3. Long-termIncentives - employee share ownership plans. This article focuses on long term
incentives.



Long Term Incentives

Four types of share-based long-term incentives are considered:

Real shares

Real share options

Phantom shares

Phantom share options


The choice will depend on the structure of the business, future plans for the business and its
owners, and the intended outcomes of the plan.

Benefits
Each of these structures achieves the objective of aligning an employees goals with those of the
owners, the benefits of which include:
For employers:



o Promotes increased productivity.

o Encourages a strong personal interest in raising the corporation's profits.

o Gives employees a reason to contribute to the growth of your business.

o Encourages initiative.

o Fosters an ownership culture.

o Provides incentive to attract high calibre employees - improves the ability to
recruit the kinds of people that help the business prosper.

o Promotes employee retention gives them another reason to stay.



For employees:



o Provides an opportunity for employees to share in the growth of the company.

o Reward for contribution toward growing the business.

o Gives employees more rights and responsibility, as well as risks and rewards.

o Encourages greater commitment, provided they understand how their work affects
share values.

o Provides an opportunity for employees to accumulate wealth.

o May provide the chance to participate in a public offering or sale of the company.




Depending on how the plan is structured:

Neednt force the owner to give up control.

Can be subject to vesting requirements.

Can be forfeited upon an employee's termination or departure.

Can be repurchased using payment schedules.




1. Real Shares

Shares can be either granted or sold to employees.
Benefits


Simple implementation.

Employer does not have to pay out cash if employees sell the shares; others may buy
them if there is a market for them.

A way to sell down ownership to employees.


Disadvantages


On-going administrative costs of real share plans may be prohibitive. For a private
company with 20 employees, setting up a share ownership plan could cost $30-40,000 in
advice and $5-10,000pa to run.

Additional ASIC requirements to consider.

Generally no tax benefits, unless qualifying criteria are met.

Dilutes ownership and share value.

Small, closely held companies that dont want to go public or be sold may find it difficult
to create a market for the shares, making them difficult to sell.

Real shares may need to be repurchased under the terms of a buy/sell agreement when an
employee departs or is terminated.


Selling your Business through an Employee Share Ownership Plan (ESOP)
One way to sell your business to your employees is through an ESOP. 12% of all business sales
in the USA are now made to "all employee" entities. This includes MBOs.

ESOPs are tax-qualified employee benefit plans that invest primarily in shares of the
employer.

An ESOP may suit business owners who want to move gradually into retirement,
providing a transition plan.


Tax

Care is required regarding Fringe Benefits Tax (FBT), Capital Gains Tax (CGT) and Payroll tax.

There are tax concessions designed to encourage the establishment of ESOPs in Australia. These
may be available to an individual selling the business to an ESOP and the employees
participating in the plan. Qualifying plans provide shares or rights tax free to participants. No tax
is payable on receipt.

The tax incentives and benefits of employees having ownership in the business make such plans
attractive even when business owners wish to sell only part of their businesses.



2. Share Options

Share options grant employees the right to buy company shares at a specified price within a
specified period. The price at which the options are provided usually reflects the value of the
company at the time the options are granted. Employees hope that the value will go up. If the
shares are openly traded, they will be able to "cash in" by exercising (purchasing) the options at
the lower price and then sell the shares at the current market price.

The benefits of Share options are limited to the increasein value of the shares over
the exercise price of the options, rather than the underlying value of the shares. This distinction is
important, as the stronger the company's growth the greater the reward.

Employees typically do not own the shares outright when options are granted. Share options vest
(or become theirs to exercise) over a period of time, usually a number of years they stay with the
company.
Benefits


Reward employees based on the increase in value of the company.

For growth-oriented smaller companies, options are a great way to preserve cash while
giving employees a piece of future growth.

Granting options incurs no charge to earnings.


Disadvantages


Option plans that allow employees to sell their shares a short period after granting do not
create long-term ownership vision and attitudes.




3. Phantom Equity

Large companies have the advantage of offering employees share options, but these may not be
practical for start-ups and smaller businesses. Not every company owner wants to open up the
share register to others.

Instead of giving employees real shares, a phantom equity program gives employees something
that looks and feels like shares, but without transferring actual shares. Phantom shares and
phantom share options mimic the company's real shares and options but offer no rights to actual
shares.

There are a number of situations that might call for a phantom share plan:

The owners want to share the economic value of equity, but not equity itself.

The owners have considered real equity plans but found the rules too restrictive or
implementation costs too high.

The company is a division of another company, can create a measurement of its equity
value and wants employees to have a share in that value.


Phantom equity is an agreement between the owner and the employee which rewards the
employee based on growth of the company. It is simply a promise to pay a bonus in the form of
the equivalent of either the value of company shares or the increase in that value over a period of
time.

Most phantom share agreements provide for paying bonuses to employees as though they owned
shares. The bonus may be paid in cash, real shares, share options, promissory notes or other
consideration.

Hypothetical shares are allocated by book entry to an employees account. As the value of the
company grows, so does the value of the phantom shares. If the employee remains with the
company until the end of the restriction period, then the phantom shares are converted into actual
shares or cash, or both. The employee is entitled to receive the difference between the market
share value and the phantom share value. This payment is sometimes received in instalments.

The owner effectively buys back the phantom shares with cash or pays out the increase in the
value of the shares; or can convert to real shares.

A written agreement and a corporate resolution are drawn up. The arrangement is valid if:

the corporation receives some type of adequate consideration for the payments to the plan
participants; and

there is a reasonable relationship between the value of the services rendered by the
participant and the benefits granted to the participant under the compensation plan.


Rights of the employees, particularly as to their ability to redeem phantom shares, must be
carefully structured to ensure the correct tax treatment and the desired deferred compensation
incentives to attract and retain employees.
Benefits


Flexible - can be tailored to precise business objectives as there are no regulatory
requirements to be met.

The benefits can be directly related to the achievement of designated criteria.

Phantom share options can be converted to real shares without causing as much dilution,
as there are fewer shares than would be needed with real share options.

Can be tied to how long employees stay with the company and how well the business
performs.

Gives employees the economic benefits of owning shares without any actual transfer of
shares.

Allows employees to participate in the financial rewards of ownership without having a
voting interest and without the complications associated with having additional
shareholders in the company.

There is no dilution of the ownership rights of existing shareholders as no share is
transferred on exercise of the option.

Phantom shares can disappear, based on certain triggering events (ie. If an employee
leaves within a set period).

Phantom shares can also be valued using any formula that an owner and his advisors
deem appropriate.

Employer is free to pick as few or as many participants as needed, with complete
flexibility for each participant's plan design.

No cash outlay to purchase phantom shares.

Administration cost of the plan is minimal.

Tax advantages are attractive to both business owners and employees. When the
employee receives phantom shares, the receipt is not taxable income to the employee
until he or she actually receives the money or other benefit. The company is entitled to a
tax deduction for the full cost of payments under the plan.


Disadvantages


These programs are usually unfunded, with the benefits dependent on the solvency of the
company at the time the funds are to be paid.

If paid out as cash bonuses, this can impose a cash drain on the company. Issue too many
share options, and you may have to pay out an enormous amount of cash.

Superannuation guarantee contributions are payable.




4. Phantom Share Options

The phantom share option plan works in the same way as a company share option plan, where
the bonus is determined by reference to the increase in value of the shares subject to the option.
The difference is that no shares are actually issued or transferred on the exercise of the phantom
share option. The benefits, however, can be just as real.
Benefits


Rewards are based only on the increase in the value per share between the date of the
award and the date of distribution.

There is no exercise cost to the employee, as there would be with a real share option.

With options, the employees only participate in the additional value that they help to
deliver and do not participate in the value that already existed.




Phantom Shares vs Phantom Share Options

With phantom shares the employee receives the underlying value of the shares, as well as
any appreciated value. Whereas, with options, the employee receives only the
appreciation in the share value.

Phantom shares are a benefit in themselves, whereas options only reward employees for
increases in company value.




Design Considerations

The success of the employee share ownership plan depends on the employer choosing the correct
plan to achieve the desired goals.

Prepare a shareholder's agreement - a written plan document specifying the following:
A. Class of shares and their rights:



o Special classes of shares exclusively issued and held by employees. Eg non-
voting common or preferred shares.



B. Quantity:



o Work out the number of shares or share options to make available.

o Avoid giving out too much to early participants and not leaving enough for later
employees. Consider how many staff youll have, so that the right number of
shares is granted each year. A common error is to grant too many options too
soon, leaving no room for additional options to future employees.

o Each employee who participates in the plan is granted a certain number of shares
or options.

o Place a limit on the total number of units that may be outstanding at any one time
and the number that may be awarded to any one employee.



C. Decide who can receive and when:



o Which employees are eligible to receive the shares or options eg all or only key
employees.

o The basis of making available eg. time, % of salary or perceived value to the
organisation.

o When employees qualify to receive them, eg. after 6 or 12 months

o Rate at which employees can receive options over the course of their career.

o For each year employed, opportunity to earn additional options, which will also
vest over time.



D. Holding Period


Require a minimum holding period. If the employee leaves before the holding period
expires, the employee forfeits the shares.

If the employers sole objective is retention, the forfeiture provisions may be based solely
on the passage of time (eg. a five-year cliff vesting schedule, meaning the award does not
vest at all until the end of the fifth year, at which time it becomes 100% vested).


E. Valuation:

Determining what your company is worth is essential when setting up the share plan and making
other financial arrangements. Owners often think they know their companys value, but they may
be shockingly misinformed. Most misjudge the value of their businesses by 50% or more. So be
sure your business is properly appraised before implementing any financial plan.



o A Good Valuation is essential.

o Decide how the shares will be valued and who will determine the value.

o Define a formula or methodology for valuing the shares.

o Provide for an objective valuation method which is perceived as fair by the
participants.

o Avoid static valuation formulas as these may negatively influence employees
behaviour.

o Consider professional valuations or a group of indices, such as earnings per share,
return on assets, return on equity.

o Valuation of phantom shares can be based on a simple standard such as the
current book value of actual company shares.

o As the value of the company rises, so does the value of the phantom shares.



F. Vesting Schedule



o Help retain key individuals through the use of vesting schedules which give
employees ownership of their shares gradually over a specified time period.

o The employee only obtains the benefits by remaining with the company for a
certain number of years.

o Establish a universal vesting schedule or tailor to individual circumstances.

o The vesting schedule may be designed with specific objectives in mind.

o You can negotiate vesting individually to take into account the person's age and
how much value you expect him or her the employee to bring to the company
over the short and long term.

o Vesting periods of 5 and 10 years have been used ie. 20% and 10% pa.

o Each year for 10 years the employee earns shares equal to a % share of the
company's assessed value.

o If the objective is a combination of retention and performance, the vesting
provisions can be tied to the achievement of certain financial targets.



G. Conversion of Options to Shares



o After the shares are fully vested, convert the options to shares by buying them for
the option price.

o Decide when the options can be exercised.

o If you hope your employees will buy the shares and keep them, you may also
want to provide assistance in financing the exercise price through employee loan
programs. Eg. low or interest-free loan.



H. Payouts



o Design the rules and timing for the withdrawal of earnings under the plan.

o You can also establish a payout period, after which time you will redeem the
phantom shares for cash. In other words, your people do not have to leave the
company in order to cash in their shares. You have some flexibility in determining
the timing of the payment of phantom shares.

o At the end of that time, the employee may cash out over a 10-year period,
collecting not more than 10% of the accumulated value each year.

o Define the terms and conditions under which shares can be sold, eg. only back to
the company or on the open market if available.



I. Transfer Restrictions



o Eg. cannot be exercised by anyone other than the option holder.

o Cannot be transferred by the option holder other than by will or by the laws of
descent.



J. Employee Beneficiaries



o Designation of beneficiary and a contingent beneficiary for each employee.



K. Restrictive Covenants



o Employees may be required to agree not to compete with the company, not to
become a competitor's employee after retirement or solicit employees or
customers for a number of years following termination of employment.

o Employees may be required to agree to remain employed by the company for a
certain number of years or until retirement.

o An employee must carefully weigh the benefits of participating in the plan and the
associated decreased career mobility.



L. Escrow



o The company may use a restriction period to prevent any employee who leaves
within a set number of years from receiving shares or cash.



M. Change of ownership



o Provisions to make the contract binding, even if someone else purchases the
company.



N. Accounting



o Each unit reflects a percentage of the total value of the company.

o The employer establishes a "share account" for each participant.

o The employee is credited with "shares."

o A bookkeeping entry is made to that account each time shares are granted to the
participant.

o Each year the employee becomes vested in shares in accordance with the written
agreement.



O. Funding



o The plan can be informally funded to offset all costs on an annual, after-tax basis
and to recover all costs over the working lives of the participants.



P. For a Phantom Share Option Agreement



o Set the minimum exercise price for the shares.

o Set the period during which the options may be exercised.

o Define specific periods for exercising the options under the plan.

o The company must decide whether it should grant options with an open-ended
commitment as to the amount of bonus which may become payable when the
options are exercised. It is fairly common to place a cap on the amount of bonus
which is payable. There are several ways to cap the payment.

o The company can also establish a policy in connection with the grant of options.
Exercising of options can be subject to performance targets.



Q. Tax

There is no difference from any other salary or cash bonus plan. The employee does not
recognise income when the phantom shares are granted, but must recognise ordinary income
upon receipt of the cash bonus. The employee is taxed at ordinary income tax rates, and the
employer receives a tax deduction at the same time.

The employee can effectively defer payment of taxes on this benefit until a liquidity event or
retirement occurs. The time value of deferring these taxes can be significant.

When the company pays an employee to redeem phantom shares, the company can treat it as an
expense rather than a repurchase of shares and the company receives a tax deduction.

When the right to the benefit is exercised, the value of the award is taxed as ordinary income and
is deductible to the employer. If the award is settled in shares, the amount of the gain is taxable
at exercise, even if the shares are not sold. Any subsequent gain on the shares is taxable as
capital gain.

Where to go from here?

We recommend you educate yourself further and hire the right people to help you through the
process. This will include your Accountant or other Professional Advisor with experience in
implementing employee share structures. Your Accountant can provide specialized advice across
the key accounting and tax areas which will need to be considered in your individual
circumstances. Whilst Supertrac's advisor network includes qualified accountants, specialist
advice is required to determine the optimal structure for your business circumstances (if any).
This article is based on research for our own organisation, as well as an accumulation of pieces
of advice received from Clients' Advisors in the past. We recommend you consult with your
Accountant or other Professional Advisor qualified to provide advice on your specific situation.
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Tony Brown ( View Google Profile )
Tony Brown is Managing Director of Supertrac, a corporate advisory firm specialising in
business divestments, mergers and acquisitions in the SME market across Australia and New
Zealand.

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How to structure business sale transactions to create bonus value for all parties |
Supertrac Blog Friday, 06 December 2013
[...] Supertrac has previously covered some of the scenarios that can be built in to
accommodate key managers: http://www.supertracblog.com/how-to-get-your-employees-
to-think-and-act-like-owners/ [...]
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Developing your mental toughness can help you be more emotionally resilient, push you to go
further and harder, and build armor to persevere against the bullets that life fires your way. It's
not as easy to just "be tougher," though. Here are some tactics to toughen up your mind for life's
hard knocks.
What is Mental Toughness?

"Mental toughness" is keeping strong in the face of adversity. It's the ability to keep your focus
and determination despite the difficulties you encounter. Events in our life rarely go the way
we'd like them to, but that doesn't mean you have to let it throw you off your game. Mental
toughness gives you the tenacity to learn from your mistakes without the devastating blow failure
can sometimes deal. This resilience and fortitude also gives you the strength to keep emotions in
check when something in your life seems overwhelming and you need to be strong. Essentially,
mental toughness is the voice in the back of your head that tells you to keep going, keep pushing,
and keep trying, even when the going gets tough. They say "life's tough, get a helmet." These
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your morale and weaken your mental fortitude. Flexibility and the ability to adapt to situations
are key components to laying the groundwork for strong mental resolve. Christine M. Riordan at
Forbes explains how a leader with flexibility can stay mentally strong, but the same can be said
for anyone:
Game-ready leaders have the ability to absorb the unexpected and remain supple and non-
defensive. They maintain humor even when the situation becomes tough. If something isn't going
well or doesn't turn out as expected, they remain flexible in their approach and look for new
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hard to see the true causes of events when your vision is clouded with immediate emotional
responses. Wait five minutes to respond to something when you have the time. Or pretend like
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No one knows you more than you, but when you run from difficult circumstances or
uncomfortable situations, you don't even give yourself the chance to prove that you can
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Even if you maintain realistic expectations, and you're capable of keeping emotions in check,
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your next workout, you need to stay motivated. So where do you find motivation? The simple
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Why do I need to solve this problem?
Why do I need to get through this?
Why do I need to get stronger, faster, healthier?
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Because I want to be better at what I do.
Because this person needs me.
Because I want to live longer / look a certain way / feel a certain way.
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explains that the development of mental toughness can stem from looking at failure as a delay of
gratification:
...accepting failure, being okay with not getting what you want right now, is one of the best, best
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make yourself work hard and wait patiently, you will understand what it means to have mental
toughness. You need to let go of mistakes quickly if things don't go your way, and understand
the time and patience it takes to accomplish things. Mental toughness is as much about telling
yourself no, as it is about telling yourself that you can persevere.
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through whatever comes your way, but you can't impact every single thing out there. You have
to accept that you can only control so much. Jeff Haden at Inc. suggests putting aside things
you can't control to save energy for the things you can:
Mental strength is like muscle strengthno one has an unlimited supply. So why waste your
power on things you can't control? For some people, it's politics. For others, it's family. For
others, it's global warming. Whatever it is, you care, and you want others to care. Fine. Do what
you can do: Vote. Lend a listening ear. Recycle, and reduce your carbon footprint. Do what you
can do. Be your own changebut don't try to make everyone else change.
Remember, mental toughness is about building the strength and resilience to do the things you
need to do and the things you want to do. Don't make it harder on yourself by trying to keep
strong for something that doesn't benefit you or your goal. Some things you just have to
completely let go.

Developing mental toughness is a process and it's not something you can conjure overnight. It
takes a lot of patience and a conscious effort to become more resilient. Some things are bigger
than all of us, but mental toughness can be your armor that glances the smaller blows away. If
you have reasonable expectations, control over your emotions, strong motivation, and the
patience to see things all the way through, you won't ever sweat the small stuff and you'll be
better equipped to handle the big things in your life