Integrating employee share ownership scheme in SMEs

An employee share ownership scheme colloquially known as ESOP refers to a scheme/arrangement by a company to afford its senior employees an opportunity to own shares and participate in the ownership and decision-making in the company.

Usually, ESOPs allow employees to acquire shares at a discounted price or at a fixed price over a duration of time. It is notable that such a scheme has been known to foster employee loyalty and investment in the performance and profitability of the business of the company.

Ultimately this leads to growth and maximisation of shareholders wealth which is the pinnacle goal of any profit-driven venture. In Kenya, ESOPs are regulated by the Capital Markets Authority Collective Investment Scheme Regulations of 2001 and are required to be registered with the Kenya Revenue Authority.

While these regulations relate to ESOPs established by listed companies, this has not barred and or deterred private entities from establishing ESOPs for their employees.

Startups and SMEs have in the recent years been the drivers for economies across the globe and as their businesses evolve and morph into sophisticated entities it may be worth considering ESOPs as means to retaining integral staff who are well versed with the history, vision and humble beginnings of the business.

It is also a strategic move to protect trade secrets, intellectual property, and other proprietary and business interests of the company.

The practice in establishing ESOPs is to set up a trust fund where the company contributes new shares or funds to buy the existing shares of the company. The company may also borrow money from banks or other sources and contribute to the ESOP fund to buy new or existing shares of the company.

Thereafter a trustee is appointed to hold the shares in trust for the employees. The shares so held in trust vest in the employees over time and as per the terms of the trust deed.

Usually, the longer an employee works in the company or the higher they ascend on the corporate ladder, the more shares vest in them.

Depending on the terms of the trust deed underpinning the ESOP, employees may be entitled to pay-outs in the course of their employment based on the shares vested in them at the material time. These are treated as employment benefits and are allowable deductions on the income of the company.

In other instances, the shares vest upon the lapse of a fixed duration of time or subject to other considerations.

Upon retirement or exit from employment, the trustee to the ESOP trust fund may repurchase the vested shares and pay out to the exiting employee an amount equivalent to the value of the shares vested in them.

Alternatively, the trustee may in a separate private transaction, transfer the vested shares to the exiting employee, whereafter the employee becomes a shareholder/investor in the company and are eligible for dividends and other benefits and obligations attributable to equity owners in a company.

To a startup or a small and medium enterprise, an ESOP provides a compensation structure for employees that does not involve direct cash payouts from the company such as pension schemes or bonuses, which would be ideal in preserving the resources of the enterprise particularly at the developmental stages.

ESOPs are often coupled with non-compete agreements under which employees undertake not to establish or set up competing businesses during or after cessation of employment, or work for a direct competitor of the company for a stipulated period of time. They also undertake not to reveal any trade secrets acquired in the course of their employment.

Startups and SMEs are the hub for a lot of innovations and disruptive concepts particularly in this digital age, it is therefore paramount that they protect their proprietary information and technical know how and an ESOP would be worth considering in this regard.

ESOPs have been in recent years famed as alternative exit strategies for aging owners particularly in businesses rooted in family, personal values, and other personal considerations in comparison to mergers and acquisitions which have considerable regulatory, disclosure and compliance issues, not to mention the cost implications.

Here ESOPs are seen as a gradual way of passing the business on to employees who have dedicated their lives to the business and embody its values. This has also been seen as a solution where children in family-owned businesses are not keen to take on ownership and management of the family business.

An ESOP in and of itself is a corporate finance mechanism. It allows the company to raise funds from its employees whether at a discounted share price or at the fixed price offered. It also offers a ready market for all or some of the shares of the company available or to an exiting shareholder.

The tax benefits associated with ESOPs are innumerable. For instance, contributions to an ESOP are tax-deductible. Dividends paid on an ESOP and utilised to repay a loan acquired to finance the ESOP are also tax-deductible.

If paid out to an employee, they would be treated as an employee benefit and subject to employment taxes. To an individual shareholder wishing to exit the company, they may sell their shares to the ESOP and defer capital gains tax obligations.

Tech startups have been known to give their integral development staff a stake in the Company to stay the course even at the formative stages where the startup is not necessarily profit-making but where they buy into the vision of its founder.

It would then seem to be in the interest of the start-up founder to set up an ESOP where they can delineate the rights of the employees and make them subservient to those of the founders as opposed to giving an equity stake similar to that of a founder.

While ESOPs are not common in Kenya, it may be time to consider entrenching an ESOP culture in corporates particularly startups and SMEs and reap all the benefits that it portends.

Ms Mugo is a legal manager at CM SME Club, a virtual legal platform offering proactive legal solutions tailor-made for SMEs and family-owned businesses