Employee stock ownership plans as reward strategy

• Issue its own shares direct to its employees; or

• Allow its employees to buy shares in the company at less than market value; or

• Grant its employees an option to buy shares in the company at some future date. There are many variations of ESOPs, depending on the specific objectives of management and the risk appetite of the employees.

Examples include employee share ownership plans, stock options, employee stock purchase plans and stock appreciation rights.

Perhaps the greatest benefit of ESOPs is their potential effect on employees.

This is because a bit of the company ownership is vested in the employees, which results in “employee-owner” attitude and behaviour on the part of the employee and ultimately a greater need to generate wealth by the employee, since he himself will benefit as a shareholder.

Today, more companies realise that their products or services are no longer the differentiating factor in the market. Their products or services are actually an entry point in the market while employees are the differentiating factor.

Indeed, research has shown that people buy from people they like — a fact summarised in the maxim “people buy on emotion and later justify on logic”.

Therefore, in order to remain competitive and retain top talent, employers must consider innovative ways of incentivising their employees, and ESOPs are one such way.

While ESOPs are relatively new in Kenya, they have been used as an employee compensation strategy for over 50 years in other parts of the world.

For example, in the United States, the first ESOP was established in 1956, while The Employee Retirement Income Security Act of 1974 (ERISA) set the legal framework within which such plans should operate.

Potential benefits
In Kenya, since ESOPs are now recognised under Section 5 of the Income Tax Act and as investment vehicles under the Capital Markets Act, companies should consider the potential benefits of ESOPs.

There are three important stages in any ESOP: Grant – when the employee is given the right to acquire shares of the company, usually prospectively upon attaining set KPIs. Vesting — the unconditional right to acquire the shares accrues to the employee and he can exercise his rights to acquire the shares.

Exercise — when the employee acquires the vested shares at the strike price i.e. share price agreed at the grant date.

ESOPs are a clear favourite for small and medium size enterprises when developing an incentive compensation structure, principally because they do not involve a direct cash outflow, like a bonus payment would.

However, before a company can settle on an ESOP as a way of compensating its employees, it needs to consider several issues.

Its employee demographic profile – a company must consider its employees risk appetite.

Older employees tend to be more risk averse and would generally prefer a compensation structure that is less risky and more structured and certain, such as higher contributions to a pension plan.

The legal issues surrounding an ESOP. There are two main challenges to an ESOP.

One is whether from a tax perspective, the expense should be treated as a revenue expense (employee cost) and therefore allowed for tax purposes or whether this is a capital expense (issuance of additional shares) that is not tax deductible.

Tax liability
Tax point — it is important to plan for the point at which the tax liability crystallises on the employee (tax point) to avoid instances where an employee is taxed on the benefit accruing from the ESOP yet he will never exercise his options. Some companies have developed unique shares such as phantom stocks as a way of addressing the tax point issue.

Marcus Buckingham and Curt Coffman note in their book, First Break all the Rules, that “many companies know that their ability to find and keep talented employees is vital to their sustained success”.

Therefore, retaining top talent in the face of stiff competition for such talent dictates a need for companies to present employees with novel compensation structures that will encourage talented employee retention and greater wealth creation for the benefit of both the employer and employee.

Waruiru is a Tax Manager at KPMG Kenya. The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG.