Cash Based Incentives
Cash Based Incentives
Why use cash?
Employee share schemes offer many advantages and attractions. They allow for the sharing of ownership. They align the interests of employees and shareholders. They are encouraged by Government and as such will often offer tax benefits if structured correctly. They also provide a ready way to reward and retain employees without an immediate cash cost.
Despite that, making awards to employees over shares is not right for all companies. In some cases, the difficulties with share ownership may be too problematic and outweigh the benefits. There are a number of reasons why this might be the case.
- With family companies, there may be sensitivities with non-family members holding shares.
- The voting balance of a private company may be distorted if new shares are issued.
- A listed company may have exhausted its headroom limits under the guidelines of institutional investors which have been embedded in their share plan rules.
- There may be concerns with senior employees continuing to own shares after they leave employment with the company.
Depending on the context, these issues can usually be managed within an actual share scheme. An alternative, though, would be to deliver a cash based incentive. This can be structured as a phantom share plan – i.e. a cash based plan which replicates the commercial effect of a share based plan but without using actual shares.
One of the benefits of a phantom plan is its flexibility. Consequently, there is no single structure. Typically, though, it would contain the following features:
- Deferred payment contingent on remaining in employment and specified performance targets being reached.
- The cash payment being determined by the value of the shares in the company at the time of payment. This might be determined by the full value of a number of shares at that time (replicating immediate share ownership) or share price growth since the making of the original award (as with a share option).
- Clear criteria for valuing the company.
- As with a share plan, provisions for early payment and termination of awards in the event of a sale, flotation or other major company event.
Valuation is a key issue where the plan relates to a private company. The basis for measuring underlying share values is central to the whole plan. Without clarity on that, there is scope for uncertainty, conflict and in the worst case, litigation.
This will need to cover:
- Valuation on award.
- Valuation throughout the life of the scheme (in order to maintain communication with participants).
- Most importantly, valuation on exit and payment.
- Determining in each case the factors to be taken into account in determining value – e.g. will there be a discount to reflect minority shareholdings? If so, will this apply both on award and exit when the circumstances of the Company may have changed?
While tax incentives are linked to plans using actual shares, the tax treatment of phantom schemes should not be problematic provided that they are structured correctly. In outline, the tax treatment will normally be:
- Corporation tax relief for payments when made (but not when accrued in the accounts).
- Income tax and national insurance contributions when paid.
The accounting treatment of the plan will also be important both because of the effect on profitability and the relationship between the accounting profit, valuation of the shares and therefore the amounts of payments to be made under the plan.
Broadly, the normal accounting position would be to make a provision for accruing payments during the life of the award to reflect the increasing value of awards subject to satisfaction of service and performance conditions. However the share based payment rules for Cash Settled Share Based Payments may be applicable
How Pett Franklin can help
With phantom schemes, we can help with:
- Plan design;
- Share valuation;
- Tax advice;
- Preparation of plan documentation;
- Plan communication;
- Accounting; and
- Reporting requirements.