When it comes to compliance, nothing is more important to businesses operating in South Africa than having a strong Broad-Based Black Economic Empowerment (B-BBEE) score. B-BBEE is not only a compliance requirement, but also a deliberate policy that aims to amend the past and its effects on black-owned businesses.
Every business operating in South Africa has a B-BBEE score it needs to hit to ensure strong compliance. There are many ways to meet B-BBEE requirements, and many depend on the sector in which you are operating. One less explored method is developing an employee share ownership plan (ESOP).
Developing an ESOP is not only a compliance advantage, but it can also ensure that as your business scales, you keep key personnel and are able to attract skilled and scarce talent.
In this article, we look at what an ESOP is, how to develop your own and the benefits of having one.
What is an ESOP and Why Does It Matter
An Employee Share Ownership Plan (ESOP) or equity compensation is a formal structure that allocates shares or share-linked value to employees, giving them a direct economic stake in the growth of the company. ESOPs typically operate through a trust or pool in which the company places shares (or rights to shares), distributing them to employees over time according to predetermined rules.
At its core, an ESOP is both a financial instrument and a cultural signal. It tells employees that they are not merely hired hands but co-builders.
Types of Equity Compensation
There are various forms and plans that come with equity compensation. Let’s look at five types and how each one works.
1. Stock Options
A stock option is a popular equity compensation form. It provides employees with the right, but not the obligation, to purchase company shares at an initially agreed price (i.e. exercise price) after a vesting period. Vesting is the process of earning full ownership of an award. With stock options, the value of your award will depend on how the stock price has performed against the exercise price.
2. Restricted Stock Units (RSUs)
Restricted stock units are a type of equity compensation with less risk, as they’re typically granted for free, meaning you don’t have to purchase (i.e. exercise) the award. You earn the full value of the shares after any vesting requirements are met.
3. Stock Appreciation Rights-Compliant Schemes and Phantom Stock
Stock appreciation rights and phantom stock are a form of equity that don’t really use stock but still rewards employees with compensation that is tied to the company’s stock performance. So, participants are not shareholders and don’t have voting rights.
4. Performance Shares
Performance shares will vest when employees meet specific performance-related goals. These awards are frequently allocated to company executives and directors as an incentive to achieve particular performance targets.
5. Employee Stock Purchase Plans (ESPPs)
ESPPs allow participants to purchase stock in their companies at a discount – often between 5-15% off the fair market value (FMV). This is done by making contributions directly from employees’ salaries using after-tax Rands over a set period of time. Their accumulated contributions are used to buy company shares at the purchase date.
Benefits of an ESOP in South Africa
The most important benefit and key driver of ESOP implementation is the ability to achieve positive B-BBEE ownership outcomes. This provides a more localised economic benefit because it benefits employees who supported the business on its journey to success.
In the case of B-BBEE points scoring, there are certain points that are available only to broad-based ownership vehicles like an ESOP, or to limited “designated Black groups”. To qualify for B-BBEE ownership recognition, ESOPs must comply with Annexure 100(C) of the Codes of Good Practice, which prescribes requirements such as the appointment of fiduciaries of the scheme (including the extent to which participants appoint the fiduciaries), rules of participation, and mechanisms for distributing economic interest. These ESOP structures can also use either a trust or a company structure.
Another benefit of having an ESOP is that it provides an opportunity to better align the interests of employees and shareholders by rewarding both groups of stakeholders for improving business performance and increasing the value of the business.
Lastly, ESOPs are critical in providing meaningful financial benefits to participating employees. Beyond increasing personal wealth, from a socio-economic perspective, ESOPs increase wealth across a broad base, stimulate economic activity and growth.
How ESOPs are Structured in South Africa
In South Africa, ESOPs typically hold a minority investment in companies – usually between a 5% and 25% shareholding. The size of ESOP investment will however, be tailored for targeted outcomes and may be smaller or larger.
Common structural features of ESOPs are:
- Legal structure: Trust holding shares in an employing company/group.
- Fiduciaries: Trustees, which include founder/employer representation and employee representation.
- Participants: Eligible employees, with eligibility rules being tailored by the founder to suit the desired scheme outcomes. Also, ESOPs can be tailored for targeted segments of the workforce e.g. senior management, or all employees up to management level.
- ESOP term: Either fixed-term or evergreen, with termination at the option of the founder.
- Funding: Typically, interest-bearing vendor funding from the founder, often at a discount to fair value. Funding is secured by ESOP shareholding, with some dividends being applied to loan repayment. Notional vendor funding structures are fairly common.
- Manner of benefit: The manner of benefit is determined by the chosen ESOP structure, taking targeted employee participants into account. Usually, employees either benefit through dividend participation or through the gain in net asset value of ESOP transactions over a defined vesting period. Employees most often do not own shares but rather benefit as unit-holding beneficiaries of a trust.
- Termination of employment: ‘Good leaver’ vs ‘bad leaver’ rules, with good leavers being entitled to unvested value linked to their participation and bad leavers forfeiting value.
Requirements for B-BBEE Ownership via an ESOP
Employee ownership is specifically recognised in the B-BBEE Codes of Good Practice as one of the mechanisms to address BEE ownership, with additional points being available if a qualifying ESOP is implemented.
For B-BBEE ownership to be recognised via an ESOP, the following requirements have to be met.
- Fiduciaries: Employee participants must appoint at least 50% of the trustees.
- Beneficiaries: The scheme constitution (e.g. trust deed) must define the employee participants and their proportion of claim to receive distributions. Fiduciaries must have no discretion in the determination of the definition of participants or of the proportion of claims to receive distributions.
- Operation and governance: To achieve maximum points on the ownership scorecard, a track record of operating as an ESOP is required, or, in the absence of such a record, then demonstrable evidence of full operational capacity to operate as an ESOP.
- Provision of information and engagement: The fiduciaries must present the financial reports of the ESOP at the scheme’s annual general meeting. Participants must be able to participate in managing the scheme at a level similar to the management role of shareholders in a company. Also, the scheme constitution must be available to employees in any official language on request.
- On termination: All accumulated economic interest is payable to the participants at the earlier of the date or event specified in the deed or on termination or winding up of the ESOP.
If you are considering an ESOP for your business, it’s important to critically investigate and analyse the structural options and legal implications in order to identify what makes most sense for your business, while ensuring B-BBEE compliance. To best navigate and manage employee expectations, simple and effective ESOP communications are important, together with trustee training.
