Steve Alexander looks at the merits and pitfalls of employees taking up a shareholding in a company.
One of the options for succession planning is to transfer ownership of a company to key staff. After all, they know the business, customers, suppliers and wider industry issues. They are well placed to make an informed decision on whether to ‘leap to the other side’.
So it’s not surprising that we regularly receive enquiries asking about the merits and pitfalls of employees taking up a shareholding in a company.
Some of the reasons why employee share ownership might appeal include:
1. It locks a key person into the business, making it harder for them to leave.
2. By having some ‘skin in the game’ employees might perform better.
3. It’s part of a longer term succession plan to transfer the ownership of the company to the next generation.
4. The vendor shareholder wants to diversify risk by diluting their investment in that closely held company.
It’s not uncommon for the incoming shareholders to have little/no ability to pay for any shares. It may be because they have a young family, have a mortgage and have already exhausted their borrowing capability. They may not even own their own home.
So how does the owner transfer shares to a key employee who can’t pay for them?
Some of the questions we’re asked include:
Can I give the employee some shares for no cost?
The short answer is yes, but it will likely result in a tax issue. Transactions at less than market value often have a tax consequence. Where existing shares are simply granted or transferred to an employee for no cost, it will be necessary to consider the fringe benefit tax implications.
Can the company loan the employee some money to buy the shares and if so, what issues do I need to be aware of?
Yes, but interest should probably be charged at a market rate otherwise Fringe Benefit Tax issues could arise. There is an exemption from the fringe benefit tax rules for certain “employee share loans” where the loan is made for the sole purpose of enabling the employee to acquire shares in the company and certain other requirements are satisfied. Issues such as the terms and conditions of the loan, security and how the debt is repaid all need to be considered. If the intention is for the debt to be repaid by future dividends, how long will this take given current profitability and the company’s dividend policy?
Can I, as the vendor shareholder, lend the employee some money to settle the purchase?
Again, interest charges, security/collateral and repayment issues need to be considered. If the employee receives an annual bonus salary, this could also be used to repay the shares’ loan.
Rather than sell existing shares to the employee, can the company issue new shares?
Yes, but this may not result in any cash going to the existing shareholder. There are a number of compliance issues to address with any new share issues, both with the Registrar of Companies and IRD.
Does the money I receive for the shares have to go into the company’s bank account?
No. The money belongs to the person/entity who has sold their shares.
What compliance issues do I need to address?
The Registrar of Companies will need to be advised and the Company Register will need to be updated. Depending on the circumstances, there are also various IRD disclosures required. Depending on the percentage change in shareholding, there may also be tax issues to consider.
What legal issues are there?
Plenty. Any loan should be formally documented with details of security noted (mortgage, General Security Agreement). It is advisable to enter into a Shareholder’s Agreement and individual Employment Agreements may need to be changed.
If the new shareholder is also becoming a director, there may need to be some kind of indemnity from the current director for past events. The incoming director may need to assume their fair share of the risk by offering up personal guarantees or security against any company loans etc. We would also recommend a risk review. What happens if one of the shareholders becomes ill and cannot continue to work? What mechanisms are in place to buy them out? Where is the money going to come from?
The most commonly asked question though is “What are the shares worth?”
It’s advisable that each party takes independent advice on this. Valuing shares is a complicated process. There’s often confusion/misunderstanding that the value of a parcel of shares is a proportionate value of the business. This is not the case. The value of a business and the value of the shares are often quite different.
Steve Alexander is principal-Business Advisory at Crowe Horwath Hawke’s Bay.
August 27, 2015