A flotation can be a momentous stage in a company’s development and also for its people. Ensuring employees are appropriately incentivised and retained both before and after a flotation is one of the key challenges. Companies will also have to deal with a whole host of new considerations in relation to their compensation arrangements, including statutory and corporate governance requirements. This paper sets out some of the key issues relating to their compensation arrangements that companies will have to consider in the period up to and following a flotation.
Pre-flotation incentive plans
For many privately owned companies, incentive arrangements (particularly those involving equity) are geared towards delivering value on a flotation. A flotation can be seen as a reward to those employees who have helped to get the company to that stage, and it also provides the opportunity for employees to realise value from their equity awards. However, that can also provide challenges following the flotation, such as:
- how to retain employees, particularly if they enjoyed significant financial rewards on the flotation
- how to ensure that employees remain appropriately incentivised to drive the company forward to the next stage of its development
It is common for companies to have lock-up arrangements for directors and senior employees, so that they cannot sell any of their shares for a period of up to 12 months post flotation. However, in order to ensure retention and incentivisation in the longer term it will be vital that the company puts in place appropriate incentive arrangements.
Post flotation incentive plans
There are a number of different types of incentive plan that UK listed companies put in place, but the most common are summarised below. Companies will typically put in place any new incentive plans before the flotation, so that they can be operated as soon as the company floats. Any incentive arrangements would need to be fully described in the prospectus provided to potential investors, and companies will need to take account of the UK Corporate Governance Code and institutional investor guidelines when designing these plans (see further below under ‘Governance of Remuneration’).
Some companies will also make a share offer to employees immediately on flotation, either as a one-off or under one of the all-employee plans described below.
Directors and senior employees of listed companies would usually be remunerated through a combination of fixed salary, annual bonus and long term incentives. The main forms of long term incentive arrangement are described below.
Long Term Incentive Plan (LTIP)
LTIPs (also known as Performance Share Plans) usually give the employee a right to acquire a certain number of shares for no cost at the end of a specified period (commonly three years, but in some cases longer). The number of shares receivable is usually calculated by reference to a percentage of the employee’s salary. The number of shares actually received will depend on the satisfaction of performance conditions. Therefore, through an LTIP a company can ensure that rewards are only received if it is justified by the performance of the company over the relevant period. However, it also ensures more direct alignment with the interests of shareholders as the value of reward is also linked to the company’s share price. In order to ensure even closer alignment, employees may also receive the value of any dividends paid on the shares over the vesting period.
Share Option Plan
Under a share option plan, an employee is granted an option to acquire shares at a price equal to the market value of the shares at the date of grant. Options will usually become exercisable at the end of a three year period, subject to the satisfaction of performance conditions. Therefore, an option plan will only deliver value if the company’s share price increases. Option plans have become less popular among listed companies over the last few years, as companies have moved more towards LTIPs. This is partly due to the change in accounting treatment for options.
In the UK, it is possible to operate a tax-efficient share option plan, under which options can be granted to any one employee over shares worth up to £30,000. Provided the option is exercised after three years, no income tax or National Insurance contributions would be payable on exercise.
Deferred Bonus Plan
An increasing number of listed companies are now operating deferred bonus plans, which may partly be a trickle down effect from the FCA remuneration rules applicable to banks and financial institutions. Under such a plan, an employee would be required to take part of their bonus in the form of shares which would only be received after the end of a specified vesting period (either cliff vesting at the end of the period or pro rata each year). Deferred bonus plans may also include the facility for employees to elect to defer an additional part of their bonus, in return for which the employee may become entitled to additional shares at the end of the vesting period, subject to the satisfaction of performance conditions. Deferred bonus plans are popular with institutional investors as they ensure that short term incentives are more linked to the longer term performance of the company.
Under a co-investment plan, an employee will commit to purchase shares and will then be granted a right to receive additional shares at the end of a vesting period subject to the satisfaction of performance conditions. The employee must commit to retain the purchased shares for the duration of the vesting period, or otherwise the additional shares will be forfeited. Some plans will permit employees to designate shares they already hold as purchased shares for the purposes of the plan. Similar to deferred bonus plans, co-investment plans are popular with institutional investors as they closely align the interests of employees and other shareholders. Where employees already hold a significant amount of equity on a flotation, a co-investment plan could be used to encourage those employees to keep hold of those shares.
Phantom plans deliver rewards in cash which are linked to the share price of the company and possibly dependant on other performance conditions. Phantom plans may be used to replicate the rewards available under an equity-based plan, but where it is not possible to deliver shares for some reason. Phantom plans are relatively unusual for listed companies, as it is usually more efficient from a cost perspective (both in cash terms and from an accounting perspective) to deliver rewards through equity. However, they may be used when the delivery of shares is restricted in another jurisdiction (for example, due to securities laws). See further the section below ‘Extension of share plans to non-UK jurisdictions’.
All employee plans
One of the advantages of becoming listed is that it is much simpler for a company to offer participation in equity-based incentive plans to the wider workforce. In the UK, the two main all-employee plans are the Savings Related Share Option Plan (SAYE) and the Share Incentive Plan (SIP), both of which offer significant tax advantages to both employees and employers. However, both the SAYE and the SIP currently require specific approval from the UK HM Revenue & Customs (HMRC), which can take up to three months. Therefore, it may not be possible to operate these plans until some time after the flotation, unless there is a long lead-in time. This requirement for specific HMRC approval is being replaced by a self-certification regime in 2014.
The SAYE plan is the most popular all-employee plan operated by UK listed companies. Under the SAYE, employees enter into a savings contract whereby they save between £5 and £250 per month. At the same time, employees are granted an option to acquire the number of shares that could be purchased with the accumulated savings under the contract. The exercise price can be set at a discount to market value of up to 20%. Options become exercisable after either 3 or 5 years, and the employee then has the choice to either use their savings to exercise the option and acquire shares, or simply receive their savings back. The exercise of options is usually free of income tax and National Insurance contributions.
The SIP can be operated as a share purchase plan or a free share plan, or a combination of the two. Employees may be given the opportunity to purchase shares out of pre-tax salary (up to an annual limit of £1,500), either through monthly salary deductions or through one-off payments. Companies may also choose to match each share purchased up to a ratio of 2:1. Alternatively, companies may award shares for free up to an annual limit of £3,000. Dividends paid on the shares held in the SIP may be reinvested in further shares. If shares acquired under a SIP are held for at least 5 years, no income tax or National Insurance contributions will be payable, and they may also be free of capital gains tax on disposal. All SIP shares must be held in a UK resident employee benefit trust.
Regulation and governance of remuneration
The area of directors’ pay has been subject to significant change over the last few years, with both the government and shareholders making the case for more accountability and transparency. All listed companies have had to produce a directors’ remuneration report since 2002, but from 1 October 2013 new legislation came into force that imposes further requirements. They include:
- giving shareholders a binding vote on the directors’ remuneration policy
- giving shareholders an advisory vote on the implementation of the director’s remuneration policy
- a requirement for the remuneration report to include a single figure for the total remuneration of each director
- other requirements intended to make remuneration disclosure more transparent and to show how remuneration is linked to company strategy and performance
In addition, under the Listing Rules, there is a requirement to obtain shareholder approval for any new employee share plans (subject to certain exceptions).
UK listed companies are expected to comply with the UK Corporate Governance Code, which includes detailed requirements in relation to the governance and determination of directors’ remuneration. Institutional investor organisations such as the Association of British Insurers and PIRC also have guidelines on directors’ remuneration. Whenever a company’s shareholders are asked to vote at a general meeting, these organisations will produce reports which judge the company against their guidelines and include a voting recommendation. Therefore, most listed companies will attempt to comply with these guidelines as far as possible. One of the key requirements of the guidelines is the dilution limits that should be in share plans – the ABI recommend a limit of 10% of the issued share capital that may be issued in connection with share plans in any 10 year period (5% of which may be used in connection with discretionary plans).
Listed companies will also need to have a code on share dealings, based on the Model Code contained in the Listing Rules. The code sets out the periods when employees are permitted to carry out transactions in shares and what approvals are needed for any such transactions.
Extension of share plans to non-UK jurisdictions
A flotation will also provide opportunities to extend participation in share plans to employees outside of the UK, both for senior employees and more widely. Giving employees across the organisation, wherever they are based, the same opportunity to benefit in the growth of the company through equity participation can be an important step in making employees feel part of the business and creating a ‘corporate glue’. However, there are a number of challenges when implementing share plans on a global basis, including:
- ensuring compliance with local securities laws, exchange controls, employment laws
- dealing with different tax rules in each jurisdiction, and ensuring the correct withholding treatment
- effective communication of the share plan, particularly in jurisdictions where employees may not be familiar with the concept of employee share ownership
Summary – 10 key points in relation to compensation arrangements on a flotation
- Identify what happens to existing incentive awards – do they pay out or continue?
- Identify what share plans are required post flotation, both discretionary and all-employee plans
- Put any share plans in place prior to the flotation, and describe them in the prospectus – this will avoid the need for shareholder approval of such plans at a future general meeting
- The remuneration committee must formulate a remuneration policy for directors and executives – this policy will need to be approved by the company’s shareholders at the first annual general meeting after flotation. A key part of the remuneration policy will be (i) the maximum grant levels for directors and (ii) the performance conditions that will apply
- Consult with existing shareholders on the remuneration policy and dilution limits in share plans
- Consider how shares are going to be sourced for the purposes of any share plans – this could be through the new issue of shares, shares held in treasury or shares held in an employee benefit trust
- Consider whether to make an employee offer as part of the flotation
- Appoint administrators for any all-employee plans such as the SIP or SAYE
- Consider whether to extend any share plans to employees outside of the UK
- Ensure processes are in place for complying with regulatory responsibilities with regard to share plans – this would include dealings under the model code and any necessary public announcements in connection with share dealings
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