Key considerations when implementing employee incentive schemes

By Ben Ryan, Lawyer at Hillhouse Legal Partners
| 6 min. read

Key takeaways

  • An important consideration before offering a form of ownership/share participation is that every owner/shareholder, even minority ones, have a say in the operation of your business/Company.
  • In order to introduce a performance-based bonus your business will need to set reasonable key performance indicators (KPIs) for staff to meet.
  • If you promise too much, too early, then you may wed yourself to a position that you are unable, or unwilling, to comply with in the future.

Incentivising your staff to excel and to achieve key performance indicators can be done in many ways. However, it is important that a fair balance between incentivisation and attainability is struck and that you don’t promise too much too soon.

There are a number of options when considering staff incentives from bonuses through to share participation. An important consideration before offering a form of ownership/share participation is that every owner/shareholder, even minority ones, have a say in the operation of your business/Company.

Broadly incentive scheme options most often include:

  • Employee based bonuses;
  • A profit share in the business; or
  • Share incentives or option schemes.

Employee based bonuses:

  • In order to introduce a performance-based bonus your business will need to set reasonable key performance indicators (KPIs) for staff to meet and also to measure performance generally.
  • These KPIs can be task based, budget based or income based.
  • There are many ways that a KPI bonus can be structured also. Whether it be a fixed dollar figure, percentage or ratcheted amount. They can also be entirely discretionary and take into account non financial performance or solely linked to financial figures and payable on certain output or financial targets being met and everything in between.

For example:

a)  If fixed: “should the employee generated revenue exceed $500,000 for the financial year, the employee will receive a $20,000 incentive bonus payment”.

The problem with this structure is that an employee may either exceed the KPI significantly and expect a bigger bonus or feel unmotivated by the bonus provided as it unattainable and therefore fails to incentivise at all, or they will reach the $500,000 figure and “take their foot off the gas” as there is no incentive to further exceed.

b)  If a percentage: “the employee incentive bonus payment in each financial year will be 30% of the employee generated revenue over $500,000.

For example, if the employee generated revenue is $520,000, the employee will receive a bonus of $6,000.”This is generally a more successful way to structure these incentives as there is an incentive for the employee to continue to exceed their KPI figure. It can be a more costly bonus but if it relates to increased profits generally it is usually a “win/win”.

c)  If ratcheted: “The employee incentive bonus payment in each financial year will be:

  • “30% of the employee generated revenue from $500,001 to $550,000;
  • $15,000 plus 40% of the employee generated revenue from $550,001 to $600,000;
  • $35,000 plus 50% of the employee generated revenue over $600,001.”

A ratcheted KPI based bonus can incentivise employees to exceed KPIs and set clear boundaries for what entitlements will be. Additionally, the ratcheted approach incentivises an employee to work harder in order to  receive a greater benefit.

While revenue generation based incentives may be applicable for some businesses and staff, you may need to consider other factors for management staff or administrative staff to work toward. Of course not all staff are “fee earners” or revenue producing so different mechanisms need to developed to incentivise those staff also.

Additionally, you may want to consider whether the incentives you offer are for individuals or team based. The above bonus type arrangements are also a common choice as they aims to incentivise staff without granting them ‘ownership” and all roles, responsibilities and “say” that may come with that.

Of course, some employers are moving toward offering their employees an option to own a part of the business/ company. The most common options from least “ownership” to highest degree of ownership are below:

Profit share:

  • Profit share in employment agreement:

Whilst similar to the KPIs for an individual, this sort of arrangement would entitle employees by virtue of their employment agreement, to some bonuses based on the performance of the Company overall and possibly additional payments on certain triggering events (i.e. a business sale etc).

There is no actual “ownership” of the company or business in this instance but it can be more expensive as the payments may attract Superannuation and count against payroll tax threshold calculations etc. The payments cannot be distributed to other people/ beneficiaries by the receiving employee and so attract their usual marginal tax rates. 

Share incentives:

  • Different Class of Shares: different classes of shares can be issued which can allow for payment of dividends.

They can be structured so as to not attract any voting rights and they can vary as to whether or not they participate in surplus capital (i.e. if you sell the business and distribute the money, do they share in the proceeds or not and, if so, in what proportion). 

These shares can also be issued with particular conditions such as that they must be forfeited if the employee ceases to be employed etc. These are the lowest risk shares to issue and are usually the easiest to “claw back” if there are any problems.

  • Staged Issue of Ordinary Shares: the employee is incrementally issued with ordinary (ORD) shares in the company over time.

If you were to offer an incentive in this fashion you would need to have a detailed agreement about the terms of entry and a robust shareholders agreement governing all shareholders’ rights, responsibilities and obligations.

Because these shares would entitle the employee to participate fully in the company, their rights would be considerable.

While the employee would presumably be a minority shareholder, if the relationship sours then you will need to ensure that your shareholders agreement includes provisions around forced buybacks, valuations and dispute resolution even though they may only hold a very minor shareholding. Minority shareholder oppression and shareholder disputes are very time consuming and expensive to deal with so your documents need to govern your relationship extensively to try and mitigate such disagreement and dispute risk.

  • Full Shareholding: this is someone coming in as an equal or substantial shareholder.

If you intend to bring on someone as an equal or substantial shareholder, you will require sophisticated agreements around the terms of entry and a robust shareholders agreement to cover fundamental issues such as exit, control, dividend policy and key decision making processes. 

The risk with this offering is that you are essentially giving your current employee a piece of your business. If the relationship breaks down then you will have to pay to remove the employee. Shareholder disputes can be very expensive and devastating to the business.

If you are considering a share offer option, you may want to consider providing the option at a much higher value than the current value of the business. This should reduce the risk of any tax issues now for recipients and their option would only be exercisable if they significantly grow the business.

We find the best way forward is for you to consider broadly the type of employees you are considering offering something to, how well you know them, risks and personalities.

If you promise too much, too early, then you may wed yourself to a position that you are unable, or unwilling, to comply with in the future. If you get it right, then you can significantly improve staff morale and potentially your profit line contemporaneously.

Should you have further questions or would like to discuss your individual requirements for your practice, please get in touch with Ben Ryan on 07 3220 1144.

 

The information in this blog is intended only to provide a general overview and has not been prepared with a view to any particular situation or set of circumstances. It is not intended to be comprehensive nor does it constitute legal advice. While we attempt to ensure the information is current and accurate we do not guarantee its currency and accuracy. You should seek legal or other professional advice before acting or relying on any of the information in this blog as it may not be appropriate for your individual circumstances.