We have previously touched on the importance of shareholder agreements for small businesses. But should owners/founders always use shares and shareholder agreements to incentivize employees?
While employee share schemes are a good way to encourage talent to join a fledgeling enterprise, there can be risks in this approach down the line.
One option is to consider structuring your employee incentive scheme with a unit trust. Unit holders still retain the beneficial interest in the equity of the business, same as a share, but without the risk inherent in ‘shareholder rights’.
- Units are a fixed beneficial interest in the assets of a trust only. The trust owns shares in the main company. The trust is controlled by the majority shareholders of the company.
- Shares are issued by a company and come with various rights under the company constitution and Corporations Act.
All shareholders (including employees with shares under incentive plans) have various rights under the Corporations Act. In particular, section 232 of the Corporations Act allows shareholders to apply to have a company wound up if it can be shown there has been ‘oppressive conduct’ by majority shareholders.
However, if the employee holds units in a trust as part of a structured plan, those minority shareholders rights are not available. In theory, employee rights will be restricted to the trust and against the trustee only, not the business entity.
I am not intending to overstate the likelihood of this occurring, but dealing with oppression proceedings initiated by minority shareholders is a nightmare to be avoided if at all possible.
Principal owners will find that they have a lot more flexibility in terms of decision making.
Employees will be incentivized by a unit trust structure because, as long as they hold units, they remain entitled to a beneficial interest in the business, have little/no downside risk and may even be able to stream their entitlements to maximise tax effectiveness.
The obligations usually contained in a shareholder agreement, such as restrictions on the sale of shares/units etc., exist but are contained in a unit holder agreement.
Regulation note: Employee incentive schemes are regulated by the Australian Securities and Investments Commission (ASIC). However, in general, companies will not have disclosure obligations when there are fewer than 20 offerings, or the total value of the offering is less than $2m in any 12-month period (see section 708 of the Corporations Act). In the event these thresholds are crossed, the company will be required to make a disclosure, such as with a prospectus. Companies should also be aware that there may be obligations or restrictions placed on them when entering into loan arrangements with employees under share/incentive schemes.