Alternatives to traditional share schemes

Amanda Wilkinson finds pseudo equity and cash plans the primary drivers for organisations unable or unwilling to use shares.

Case Study: Reuters

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Traditional share schemes may act as useful tools to foster employee loyalty and to align performance with shareholder values, but for some employers they are not an option.

Employers may be wary of diluting their stock; have no shares to give, as in the case of public sector organisations or charities; or want to reward employees based in overseas countries, but they are unable to do so because of securities or tax issues.

All is not lost, however, as there are a number of ways in which employers can offer incentives similar to share schemes through pseudo schemes such as phantom equity plans and stock or share appreciation rights (Sars) and other cash bonus schemes. The appropriate course of action is dependent on what the employer wants to achieve.

In the case of phantom equity plans and Sars, these are effectively share schemes that pay out in cash, rather than shares.

"A Sars plan will pay out the gain from the starting share price to the price on the date of exercise in cash," says Marcus Peaker, chief executive of Halliwell Consulting. "Phantom equity plans are the same. Instead of being given the equity, you are given a cash payment equivalent to the value of the equity at a given point in time. So it’s a bit like a long-term incentive plan but using cash."

These types of awards have tended to be used when there is a structural issue in using the company’s shares. This can occur when a company is private and the shareholders, whether founders or venture capitalists, are reluctant to give up shares, but want to find some way of giving employees a piece of the action. International companies may also find that it is not possible to provide shares to eligible employees based overseas through their share schemes. This may be because the countries concerned have legislated against workers holding shares in foreign companies, or require the companies to jump through such regulatory, administrative or tax hurdles that it is not cost efficient to issue shares through traditional schemes.

In the past, Vodafone, which now operates formal share plans for employees, has resorted to phantom plans. Derek Steptoe, group compensation and benefits director at the telecoms firm, says: "At the time we couldn’t use proper equity. It was an interim measure until we had an opportunity to introduce a formal share plan. It was where we didn’t have a 100% ownership of certain companies at certain times."

Rather than just linking cash payments directly to the share price, other types of formula can also be used. This is relevant where a corporate group wants to use another barometer to measure and reward the performance of employees in a subsidiary or division, other than through the share price, for example increasing production or profitability of that particular business. Organisations that don’t have shares to give away, such as charities or public sector bodies, may also want to devise a formula, possibly linked to completing a contract on time and under budget or savings made.

Whatever the type of scheme, the key is working out how the plans are going to be paid for, says Sarah Pickering, a partner at Ernst & Young. She adds: "You want the plans to be self-financing. Where they are not linked to the share price, you have to be very careful that the formula you put in place does not create a situation where the individual is being paid more than the income or saving returned to the organisation."

The other issue is getting the timing of the pay out correct so that there is cash available. This can be achieved by linking it to an exit event for the company such as a sale, float or merger.

Barry Young, head of share schemes at consultancy firm MM&K, suggests a hedging arrangement in the case of a listed company: "I certainly would hedge, buying the shares and putting them in a trust, probably spreading the cost of the shares, buying some cheap and some not so cheap. It saves paying out a huge sum right at the end."

Another way of controlling the level of cash exposure, says Nicholas Stretch, incentives partner at law firm Norton Rose, is by capping the pay out. "The disadvantage of phantom plans is that they cost the company a lot of cash, whereas share schemes don’t use cash."

Phantom plans, Sars and other cash plans are also less attractive to employees than Inland Revenue approved share schemes, because income tax and national insurance are due on the cash payments received. However, the company is entitled to a corporation tax deduction for the full cost of the payments under any phantom or Sars plan.

Phantom Sars and cash plans must be accounted for in the profit and loss account, as share options are now, following the recent changes to the accounting rules. Peaker says that such cash arrangements could end up attracting a greater cost. "The profit and loss cost of share options and long-term incentive plans (L-tips) is fixed at grant, whereas the profit and loss cost of any cash or phantom arrangements is fixed at the point the organisation provides the benefit, so there is a lot more volatility in costs," he adds.

Although companies are looking at alternatives to share option schemes, following the accounting changes and the lacklustre performance of the stock market since the boom of the 1990s, many are not turning to cash-based arrangements, says Michael Carter, a partner in the executive compensation people services practice at KPMG. "Some are, but typically shareholders are looking for executives to build up shares to align their interest with those of shareholders," he says.

"Over the last year, I think there has been a move away from options towards free shares." But Stretch claims that more companies may look at cash-based arrangements because the tax benefits associated with share schemes are no longer available for some companies, and they have been eroded for individuals as salaries have risen. Pseudo equity schemes, also tend to be easier to administer, he says, as companies do not have to generally gain shareholder approval or go through formal Revenue registration procedures.

He says: "I can see why more organisations might be interested in cash plans especially when you add in the admin costs associated with share plans."

Whether the flexibility of cash-based plans will cause firms to consider alternatives to share schemes remains to be seen. For the time being, at least, pseudo equity and cash plans look as though they will continue to be primarily used by organisations that are unable or unwilling to use shares.

Phantom awards

Phantom awards arise where there is a promise to make a cash payment that is equivalent to the value of company shares or, as in the case of share appreciation rights, an increase in that value over time.

They are used when an organisation is unable to reward employees with shares for structural reasons. For instance, companies may not want to dilute their share holdings or they may have to resort to phantom awards to reward overseas employees where there are tax or securities issues.

From an accounting perspective phantom awards must be shown in the profit and loss account. Recipients pay income tax and national insurance on the cash payments.

Phantom awards tend to be more flexible than share schemes, as they do not have to be formally registered with the Inland Revenue, but sets of rules need to be drawn up.

Case Study: Reuters

Reuters is a global information company providing tailored information to financial services firms, corporates and the media. It employs more than 15,000 staff in 91 countries.

It currently operates five share plans. Discretionary Share Option Plans, Long-Term Incentive plans, and Restricted Share Plans are provided for executives. Sharesave and Annual Bonus Profit Sharing Plans are offered to all employees.

Plan rules allow for phantom awards to be made under four of the plans.

Anne Walsh, share plans manager at Reuters, says: "Our plans are global and if there are employees based in countries where exchange control laws and/or other regulatory restrictions operate in relation to the holding of shares in an overseas issuer, Reuters policy is to grant phantom awards. At exercise or release of the awards a cash payment equal to the value of the increase in the share price for options, or the market value of Reuters shares for share based awards, is paid to participants."

Cash is raised to pay the phantom awards in a number of ways. For some plans, such as the sharesave, shares are sold by Reuters to raise the cash, but in other cases the local company picks up the cost.

Last year Reuters launched a new all employee plan. The first award was made in March 2005 for the plan year 2004. Employees were awarded a number of shares equivalent to a percentage of their plan year base salary.

There is a retention period of one year after which shares will be released if employees remain in employment. Awards were made to approximately 13,500 employees, 2,000 of which were phantom awards.