It goes without saying that the last few years have been extremely tough for business owners and employees alike.

Since the onset of COVID-19, thousands of South African employees have suffered from pay-cuts whilst having to take on additional responsibilities with limited prospects of salary increases or bonuses for the foreseeable future… and those were the fortunate ones that managed to keep their jobs.

The challenges facing business owners were no less onerous with owners having to keep funders, creditors and regulators at bay to ensure the very survival of their business. At the same time, owners had to find a way to retain, and incentivise, their workforce with constrained resources and limited visibility of future earnings.

COVID-19 was not a friend to South African business by any stretch of the imagination, but it did force management teams to relook at every aspect of their business to find inventive ways to optimise productivity without increasing costs. With short term incentives, such as increases and annual bonuses, largely being curtailed, many business owners turned to employee share incentive plans (“ESIPs”) as a means to incentivise and retain key employees without the need for any short-term cash outflow.

Employee share schemes, whether effected through the actual issuance of shares in a company or through incentive structures which mimic share ownership – such as phantom share schemes or share appreciation rights schemes – are an extremely powerful tool in aligning the interests of employees with those of business owners.

There are many, significant benefits to be realised from implementing an effective employee share scheme:

• Aligning management’s interests with those of the owners thereby creating shared values in the business. This will shift management’s focus towards the generation of sustainable cash flows in the long-term rather than aiming simply to achieve short-term revenue or profit targets (which are typically associated with traditional bonus schemes);
• The attraction and retention of top industry talent who are incentivised to drive meaningful growth in the business, knowing that they will share in the value creation;
• Broadening the ownership base of the business, which can lead to improved B-BBEE ownership credentials; and
• Creating a natural succession plan for existing shareholders.

Employee share ownership is the ultimate performance management system since a company offering such a structure will attract and retain dynamic individuals who are willing to “eat their own cooking” and who are clearly committed to the long-term development of the business.

As a further benefit, the existence of an ESIP typically fosters an environment of co-operation and accountability as participants of the scheme tend to hold each other accountable to a far greater extent since a colleague dropping the ball directly affects the net worth of all participants.

Studies of employee ownership schemes consistently demonstrate the effectiveness of these structures in growing a company’s revenues and profits, improving retention rates and facilitating employee wealth creation to a far greater extent than comparable businesses with no ESIP in place.

With so many potential benefits to owners, employees and society at large, the positive intentions behind the establishment of an ESIP certainly qualifies this type of incentive structure as “the good”…

Changing the ownership structure of a business to include the employees who will ultimately be responsible for the execution of the strategic plan, is certainly one of the more noble motivations for changing a company’s capital structure.

We would argue that while ownership changes are typically set in motion to serve the needs of the primary shareholder – be it a need for succession or a need for a more diversified shareholder base – the intention at the outset of most employee share schemes is for all parties to derive benefit from the structure.

Unfortunately, in many cases, self-interest rears its ugly head and partners turn on each other to ensure that their share of the spoils is maximised. At this point, the strength and integrity of the share scheme is put to the test and the bad news, is that many ownership schemes come up well short.

At best, poorly designed and ambiguous ESIPs cause confusion and frustration for both the exiting employee and the remaining shareholders with neither party fully understanding their rights and obligations in terms of the scheme agreement.

At worst, deviously designed schemes are exposed as being nothing more than window-dressing aimed at providing a false sense of wealth-creation for the staff base. The fallout from such an ill-fated parting of ways often leads to a complete loss of faith in the scheme, and indeed, the integrity and intentions of the controlling shareholder.

In our role as court-appointed independent valuation expert, we have frequently witnessed the extent to which poorly designed and executed employee share schemes destroy value in privately held companies.

By the time Crest Capital is appointed to sort out the mess, which in many cases would have evolved over many months (or even years), growth has been stifled by internal feuds and key business relationships with customers, suppliers and employees would have suffered potentially irreparable harm.

We have witnessed disputes that have been drawn out over more than five years, at a cost of many millions in legal fees, over and above the erosion of growth and profit, with owners ruing the day they decided to share their company with employees.

Prevention is certainly better than cure when establishing an ESIP. While we have successfully restructured many poorly designed employee share schemes, altering an existing scheme is often perceived negatively by participants and, if not dealt with professionally, can cause significant disruption in the business.

Many ESIPs are designed in such a way that employees obtain equity – or a right to equity – at a discounted price, or on favourable terms (eg. through a vendor loan with a low interest rate and which is repayable out of future dividends).

Not wanting to look a gift-horse in the mouth, employees are quick to buy into ESIPs without understanding the mechanics of the scheme and, more critically, the responsibility on their part to create value, and how this value creation will be quantified.

Similarly, existing shareholders are often too quick to approve schemes in the belief that in order for ESIPs to generate wealth for employees, they will need to grow the value of the business – a win-win situation for all. This would be true in the case of an intelligently designed scheme but is not necessarily the case if appropriate performance conditions and hurdle rates are not put in place.

It is therefore critical to design a robust ESIP from the outset with the key objectives of the scheme being:

• Engagement – extensive engagement must occur between the scheme advisor, current shareholders and potential scheme participants to ensure that all parties’ aspirations and concerns are understood and that their interests and expectations are aligned.
• Transparency and procedural fairness – explaining the workings of the planned scheme to all parties is essential. As scheme advisors, we simplify and explain the process, benefits and obligations to the potential participants through a series of employee engagements. Equally, we ensure that the current shareholders understand the mechanics of the scheme. Our end goal is to ensure that all stakeholders are treated fairly.
• Comprehensive, principle-based framework – while it is not possible to establish rules to address every eventuality, the scheme agreements should set out procedures to be followed for all commonly-encountered events which would necessitate a change to the scheme structure. Examples would include a future merger or acquisition, the divestiture of a business unit or a capital raise. Principles should be established to provide guidance to all parties should an unexpected event occur.
• Consistent application – the approach to the valuation of scheme shares should be set at inception with subjective variables which will have a bearing on entry and exit prices being kept to a minimum.

The establishment of an employee share incentive plan has the potential to drive significant growth in your business for the benefit of all stakeholders, but the risks are not to be underestimated.

Crest Capital’s directors have decades of experience in guiding clients through capital structure optimisations and we look forward to engaging with you to design and implement an employee share incentive plan to achieve your objectives of profitable growth, staff retention and shareholder succession.