Should employees be compensated with stock options?

Employee stock options are schemes to enable workers to buy stakes in the companies they work for. They can be an effective way of rewarding, retaining and incentivising staff, and were historically seen as a highly desirable staff benefit.

The theory

It was thought that giving employees a stake in the company they worked for had to be a good thing as they would be more likely to have the firm’s long-term interests at heart.

Senior executives in particular, rather than focusing on quarterly or annual results to boost performance-related bonuses, would instead be in it for the ‘long haul’.

The ‘reality’

It didn’t always work out that way. Experience, especially in the US, showed that senior management would often still focus on the short term, selling newly acquired stock as soon as the latest financial results boosted the share price.

Then the global financial crisis of 2007-08 came along, and stock options became a byword for corporate greed.

In the run-up to the crisis, directors were awarding each other generous options that they sold on at the first opportunity. While they pocketed millions, other shareholders were left high and dry as markets tumbled and companies went to the wall.

When the global financial crisis of 2007-08 occurred, stock options became a byword for corporate greed: Norman Chan/Shutterstock.com

Tax breaks

So are stock options are a bad thing? Not necessarily – it depends how they are managed. In the UK, successive governments have given generous tax breaks to employee share schemes, believing it will incentivise staff, improve productivity and boost company earnings.

And it’s not just senior executives who get all the perks – two of the four schemes currently available must be offered to all staff.

With all the UK schemes, the share purchase price is determined at the time of issue. So an employee could make a substantial windfall in a successful company – a real incentive to stick around. However, when shares are sold, any profit is subject to capital gains tax (CGT).

• Save as you earn (SAYE): This allows staff to save part of their salary every month to buy share options. These can be cashed in tax-free after three or five years at a discount of up to 20%. The shares must be full voting shares, but employers can impose a minimum term of service not exceeding five years.
• Share incentive plan (SIP): A company can offer up to £3,600 worth of free shares each year to employees. They can be bought or match-funded, depending on how the scheme is set up – all free of income tax. The company can impose a minimum qualifying period of 18 months’ service and it does not have to pay employer National Insurance (NI) on the part of the salary used to buy the shares. Shares can be subject to voting restrictions, and must be held for a minimum of five years.
• Enterprise management incentive (EMI): Aimed at helping smaller companies hang on to key members of staff, shares can be allotted on a discretionary basis, allowing staff to buy up to £250,000 worth of shares without paying income tax or NI. Voting restrictions can be imposed on shares, but such restrictions must be set out when the plan is launched.
• Company share option plan (CSOP): Also discretionary in terms of who it’s given to, this allows employees to buy up to £30,000 worth of share options, which must be held for a three- to 10-year period before being converted into shares that can be cashed in. Again, there is no income tax or NI, but shares must be in the parent company, not any subsidiary, and have full voting rights.

In the UK, successive governments have given generous tax breaks to employee share schemes such as SAYE: Constantin Stanciu/Shutterstock.com

Voting rights

Voting rights are always a sensitive issue, especially with smaller companies that have issued a limited number of shares.

In the US, states such as California don’t allow the issuance of non-voting shares to staff. However, when Google went public, it issued dual-class stock, with substantially more votes per share allocated to larger shareholders than smaller ones.

Family structure

Family-owned companies such as Rupert Murdoch’s News Corp use a two-tier share structure with restricted voting rights to retain control of the business.

While this has come in for criticism from institutional investors, limited voting rights mean smaller companies can keep control of their business while also incentivising staff.

Three- to five-year buy-in periods and restrictions on how long stocks are held before they are sold should prevent the worst excesses of the banking crisis from recurring. It could be a win-win situation.