Implementing an Employee Share Incentive Scheme to weather the COVID Storm?

Covid-19 has caused unexpected financial hardships to many businesses, with companies having to conserve their cash outflows in order to stay solvent. Yet, in these challenging and uncertain times, it is only with the co-operation of the employees who continue to serve the company that a business will stand any chance in surviving, and possibly even thriving, in spite of the storm.

Many employers are now faced with the dilemma of wanting to reward such deserving and loyal talent on one hand, but on the other hand, may not have the necessary cash reserves needed to pay out cash bonuses. Short of declaring a cash bonus at the end of the financial year, such employers may wish to consider implementing an employee share incentive scheme to reward its deserving employees, or even to attract new and valuable talent to the organization.

Contrary to popular belief, there are actually multiple types of share incentive schemes, sometimes confusingly referred to by various different names. The schemes can be broadly broken down into those that involve (i) the actual ownership of shares, such as Employee Share Option Schemes (“ESOS”), Employee Share Purchase Plans (“ESPP”), Share Award Scheme (“SAS”) AND (ii) schemes that do not involve the ownership of shares being Share Appreciation Rights Scheme (“SARS”), or sometimes called phantom share plans (“PSP”).

We have previously written on ESOS in detail here. In this article, we will give a brief overview of Share Award Scheme and Share Appreciation Rights Scheme, and the practical instruments and considerations involved in implementing such share incentive schemes.

Share Award Scheme

A Share Award Scheme involves the awarding employees actual shares outright, instead of share options (being a right to buy shares in the future) to the employees, either for free or at a discount to the actual market value. Share award schemes, also known as “Restricted Shares Award” typically impose restrictions in dealing with such shares and conditions of continued employment for a length of time, in order to the shares awarded.

A Share Award Scheme is usually offered when the company wants its employees to acquire shares without paying for them or to purchase at a discounted price. To employees, it is arguably slightly more straightforward than share options, and could derive a greater sense of ownership as actual shareholders in the company at the outset rather than in the future.

The company will determine the terms of the scheme in the by-laws. Usually, under a Share Award Scheme, the employees will obtain shares on the grant date, subject to certain vesting conditions.  .

Share Appreciation Rights Plan (also known as “SARS” or “PSP” being Phantom Share Plan)

Unlike ESOS, a phantom share plan does not involve any issuance of shares to the employee. What the employer is offering is a right, at some specified time usually via vesting period and expiration period, for the employee to receive a cash award equal to the appreciation in value of a certain number of shares of the company. Share Appreciation Rights are commonly referred to in start-up lingo as “phantom shares” because quite literally, employees will not be issued any actual shares, but can enjoy the economic benefits of share ownership in the company.

In other words, employees who are awarded phantom shares will receive cash payment per phantom share upon trigger of certain events. The cash payment can be equivalent to value of appreciation (if any) of underlying shares on the award date and the value of shares on (i) the vesting date or (ii) upon a trigger event.

A SARS or a PSP contains many similarities to an ESOS. Phantom shares can be subject to vesting conditions which can be tied to the employee’s length of employment (time-based vesting) or even performance in the company (milestone-based vesting). Other salient features of an ESOS such as accelerated vesting, cancellation of phantom shares upon cessation of employment, etc can also be provided for in a PSP to suit the company’s requirements.

Critically, if a company is looking to implement a share incentive scheme but does not ever want to dilute the existing shareholding in the company at all, a PSP could be an ideal choice. Further, the employee under such plan does not need to pay for the cost of purchasing shares from the company. You can read more on the other features of PSP here.

Instruments required

Regardless of which share incentive scheme the company decides on, the company will need to prepare a By-Laws and Award Letter to implement the share incentive scheme.

The By-Laws is the main contractual document which provides for the terms and conditions of the share incentive scheme, carefully customised after taking into account various commercial factors, short term to long term objectives and the needs of the company, whereas the Award Letter will provide for the vesting terms, expiry date, and such other terms which may apply differently for different employees.

Implementation

After designing the share incentive scheme and having the By-Laws and Award Letter drawn up, the company will have to implement the scheme, i.e. awarding the share options/shares/phantom shares to the selected employees, as well as monitoring the scheme on an ongoing basis.

The implementation mechanism for each company would differ based on the company’s business objectives, but as a broad rule of thumb, here are some pointers that the company should consider in implementing the scheme:

  • Having a clear policy or methodology on who to award and the total number of shares to be awarded under the scheme. This also involves providing for the frequency in which the company awards a new round of share options. This creates greater transparency as employees will be aware of how the company allocates and selects the recipient under the scheme.
  • Be prepared to address employee’s queries, and to aid the recipient’s understanding of their rights under the scheme. Employees will usually have questions like “do I need to pay income tax if I receive payment under the scheme?”, “can I sell the shares to a third party to cash out?”, etc. One way of addressing this issue is to have a list of Q&As ready to address those commonly asked questions.
  • It is important to note that any employee share incentive scheme should be administered on an ongoing. To illustrate, the company should have a dedicated team to keep track on the company’s compliance obligations (especially in relation to the company’s tax filing and tax deduction obligations), to monitor the availability of options under the allocated share pool, to keep track of the recipient’s length of service and performance in the company to determine if the vesting conditions have been fulfilled, to manage the administrative matters when a recipient elects to exercise the options, etc.

Tax impact

Lastly, do note that benefits received by the employees pursuant to the share incentive scheme are treated as a “perquisite” of the employees under the Income Tax Act, as it arises by reason of having or exercising an employment and hence is chargeable to tax.

Therefore, regardless of which share incentive scheme the company decides to implement, the company as an employer has the obligation to notify LHDN of the launch and make the necessary tax deductions.

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This article was written by Shawn Ho and Ee Lyne Chong.  Shawn leads the corporate practice group of Donovan & Ho, and has been recognised as a Notable Practitioner, whilst the firm has been recognised as a Notable Firm for Corporate and M&A by Asialaw Profiles 2020 and 2021.  We are also ranked as a Recommended Firm by IFLR1000 2020 and 2021.

Our corporate practice group advises on corporate acquisitions, restructuring exercises, joint venture arrangements, shareholder agreements, employee share options and franchise businesses, Malaysia start-up founders and can assist with venture capital funds in Seed, Series A & B funding rounds.  Feel free to contact us if you have any queries.

 

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