Recruit, reward and retain
Article Date: May 12 2006
Flexible share schemes
More than 3.5 million UK employees now have shares or share options in the companies they work for. Where options work particularly well is when a company is building towards an exit or a liquidity event such as selling up, as there is clearly a buyer for the shares in prospect. Venture capitalists or private investors generally earmark ten to 20 per cent of the equity to be divided among the management team, although in deals heavily reliant on debt that proportion might rise to 50 per cent. One of the legacies of the dotcom era is that the proportion for each executive is usually open for negotiation.
When the option scheme is set up, a strike price is agreed with the Treasury to reflect the underlying value of the company. Executives then have the right to buy shares at this original price in a defined period with any gains treated as capital, not income, and taxed at ten per cent. If they leave the company, however, they forfeit the options.
For private companies with no plans to float or sell up, share options can still act as a powerful incentive, although it is important to be clear about the potential benefits for executives. One of the major drawbacks of giving shares in a private company is that there is often not a market for them. If a senior executive leaves, their shares are only of value if they can be sold on or sold back to the company. ‘You have to create an internal market for shares and you need some company money to create liquidity,’ says Graeme Nuttall, a partner who specialises in employee share plans at Field Fisher Waterhouse.
‘You could set up a company trust, so when someone retires or leaves, the trust has the resources to buy back their shares. Executives then know that there is a mechanism ready and waiting to buy their shares. Otherwise, they are dependent on the whim or liquidity of the owner.’
Investors might prefer executives to take a more direct stake in the future of the company by asking them to buy shares directly. This is less tax efficient and can be more cumbersome to administer. ‘You have to enter them into the articles of association,’ says Nuttall. ‘It can be difficult to make one size fit all. With share options, you can set the individual terms. For owners, there is tremendous flexibility in the rights that they can attach to shares. It is possible to create plans with non-voting shares or limited votes.’
For some private companies, it might be simpler to create a ‘backpocket’ option, which is only exercised when the owner decides to sell the company, or a ‘phantom’ scheme where rewards are linked to the company’s value.
As an alternative to share options, you could set up an employee trust, where a percentage of the equity is assigned to people who work for you, with dividends dispersed with salaries. In the event of the sale of the company, it would be down to the trustees to decide who benefits and to what extent.
Behaviour and performance
In designing packages for senior executives, make sure you have a clear timeframe, driving behaviour in both the short- and long-term, says Giles Capon, who leads the human capital practice at Ernst & Young.
‘The commercial motive underpinning the scheme might be that you want to get to a liquidity event such as a float or sale,’ he says, ‘but in private companies the long-term equity incentive tends to be a mechanism to retain the senior team rather than to tie performance explicitly to shareholder value.
‘Variable cash components, such as bonuses, can be a more effective way of linking the performance of the individual to the objectives of the business. They should be related to measures that really do make a difference, with a clear line of sight on each individual’s input.’
Capon aims to set up bonuses for his clients that generally form 30 per cent of an executive’s package and finance themselves when targets are outperformed. ‘Where bonuses go wrong is when they are expected,’ he says. ‘The criteria are not strict enough and they just become an additional form of salary. When not related strongly enough to the business plan, they can just become a poison pill for business owners three to four years down the line.’
Theory in practice
In five years, Rackspace has taken its sales from virtually nothing to nearly £40 million and has won a place in the top ten of The Sunday Times’ ranking of the best places to work in the UK. Alongside a culture of ‘fanatical’ customer support, which the UK web hoster has inherited from its Texan parent, Rackspace’s impressive performance relies on a simple set of quarterly signals linking the objectives of the business with the rewards for each individual.
Directors’ pay is linked to ‘economic value added’ (EVA), which is a single measure for net income after tax, less the cost of capital. ‘It encourages us to behave in two ways,’ says Dominic Monkhouse, chief executive at Rackspace in west London. ‘Do more with less and find more profitable customers.
‘It gives you a strong sense of ownership; you feel that it’s your money,’ says Monkhouse, half of whose pay depends on EVA.
‘If we have a dip then people will be unhappy, but it’s in our hands. We run the business. So, we look at the numbers weekly or even daily. The business is rewarding us to make the right decisions.’
Such bonuses are uncapped, although Rackspace does smooth out the differences. ‘If we are 220 per cent of our EVA goal, as we were in the final quarter of last year, we don’t pay out 220 per cent. We pay 120 per cent and bank the difference, so if we fall short in future, we can claw it back. Too often, bonuses are all upside and no
downside.’
People are also graded every quarter, allowing them to see how their earnings might progress if they score A, B or C. ‘No more than 25 per cent can be A and we try to find ten per cent who are a C. It’s too easy to give straight As,’ says Monkhouse, who ensures that all the rankings are discussed with individual team members.
Share options are available, but on a more limited basis than before, as Rackspace is close to breaching the ceiling at which the US authorities would require it to become a listed company. For Monkhouse, it is not a major consideration. ‘I’ve never been in a company where the options have earned me anything. So it’s a bit like the tombola at the village fete. If it happens, it would be nice.’
