Small business: Employee share schemes

Dan Khan - technology entrepreneur, startup adviser and programme director of Wellington-based tech company accelerator Lightning Lab.

When Facebook debuted on the stock market in 2012 it was rumoured, and widely reported, the IPO created a $1 million-plus payday for more than 1000 of the social media giant's employees.

Being allocated shares or stock options is par for the course if you're an employee of a technology startup in Silicon Valley.

But what's the situation like here?

Dan Khan - a technology entrepreneur, startup adviser and programme director for tech company accelerator Lightning Lab - was a recipient of share options when worked in the UK during the early dotcom boom, and has also incentivised employees in his own companies this way since coming to New Zealand.

"When we first started our company here seven years ago and wanted to issue share options to our employees, we went to the top law firms in Auckland and they hadn't really done any share option schemes before, so had to start from scratch. We were told that companies in New Zealand just didn't incentivise their staff in this way," says Khan.

"Over the years since, and as our technology startup ecosystems emerge and companies like Xero make such companies popular for entrepreneurs to follow, we're seeing more companies looking for template option schemes to reward their staff."

Andrew Simmonds - a partner at Simmonds Stewart, a corporate and commercial law firm for technology companies and investors - says employee share schemes have been a less common feature of our tech company landscape than in many other parts of the world.

Rather than being standard practice, they've been implemented by companies more on an adhoc basis, due both to tax considerations and securities law hurdles.

However a legislative change earlier this year has removed some of those hurdles, and Simmonds predicts such schemes will be on the rise.

"While the old securities law barriers existed, I would talk to 10 to 20 companies each year that wanted to set up schemes, but I would guess less than half of these would go ahead due to the compliance difficulties involved," he says. "This has meant there is quite a bit of pent up demand for these schemes, and I expect the number being set up will increase three- or four-fold this year."

Lance O'Grady is managing director of digital agency Pocket Square, which has been going since early 2013 and has an employee share scheme.

"Right from the start our goal was to capture an unfair share of the best talent in New Zealand, and we knew that salary alone is not what keeps people happy within a company," says O'Grady. "We wanted our team to feel as involved and important to our business as they are, and a share scheme seemed like a great option."

The founders of the company worked with their accountant and lawyer to create a company structure that would allow for an employee share scheme, and O'Grady emphasises the importance of getting this right. He also says unwavering honesty and transparency, and instituting a scheme for the right reasons - to help build and retain a great team - are crucial to making it work.

Sue de Bievre is CEO of online accounting business Beany.biz, which has been trading since October last year.

She says the startup couldn't afford to go out and hire the quality of people they wanted directly, so in the early days of development key people were paid below their market value but also offered the chance to 'work for shares'.

"This allowed the company to grow and expand rapidly without high capital requirement. It also ensured that the people involved all had a vested interest in the outcome of the business. The motivation, drive and commitment of the team is outstanding. Now we have a key member of the team who is working towards a shareholding, which crystallises next year," says de Bievre.

Her experience setting up the scheme wasn't easy; the major challenge, she says, was the lack of information available for ordinary small or startup businesses, without having to invest significant funds in legal costs.

But the benefits, she says, are substantial.

"The team we have now would have been completely outside of our range if it was not for the share incentives. Not only do we have the best team in New Zealand for our business but they are locked and loaded as far as motivation goes."

Dan Khan - Lightning Lab

Dan Khan is a technology entrepreneur, startup advisor and programme director of Wellington-based tech company accelerator Lightning Lab.

Can you tell me about your own experience with employee share schemes or options?

I was a recipient of share options when I was in the UK, during the early dotcom boom, and subsequently having come to New Zealand and set up my own companies, I've also wanted to incentivise my own employees with stock options.

There are a few different components of a share option. Firstly, there's an option for a recipient to buy a share at a certain price, usually the market value of the share at the time the options were granted. Then there are certain conditions on when the recipient can exercise that option and actually acquire the share, hopefully at a point like an IPO or acquisition when the price of that share has gone up. The difference in this price is the benefit the recipient receives.

I'm very pro-share options because the first company I worked for in the UK gave everyone options, especially as it was entering an acquisition in the early dotcom era. It was a great way to give back to everyone who helped the company be successful and make that happen.

These schemes are a real characteristic of the tech industry? Why?

Yes, these things are really prevalent in the tech industry and particularly in the high-growth startup space. These types of companies understand more than any that the success of any venture comes down to their team and the quality of execution on the delivery of the idea.

Usually people in these companies take a lot of risk getting involved very early on, with little guarantees of success and taking less than market-rate as remuneration. So share options are a great way to incentivise this sort of risk.

But further than this, they allow employees to really feel part of the company in a different way: the actual financial success of the business directly impacts the value of your shares since, in a way, you become a part-owner of the company. It also means you're more likely to be committed long term to the vision and mission of that company - especially if the exercise rights of the option only become valid after a long period of time or upon a liquidity event like an acquisition, which is much more common in the tech industry than others.

What are some of the trends that are being seen in terms of these schemes, both in New Zealand and overseas?

When we first started our company here seven years ago and wanted to issue share options to our employees, we went to the top law firms in Auckland and they hadn't really done any share option schemes before, so had to start from scratch. We were told that companies in New Zealand just didn't incentivise their staff in this way.

Over the years since, and as our technology startup ecosystems emerge and companies like Xero make such companies popular for entrepreneurs to follow, we're seeing more companies looking for template option schemes to reward their staff.

I believe the tax treatment still isn't as favourable as it is in countries like the US or UK, but this is still an opportunity for change, especially if we want to incentivise more people to come to start companies here. Other countries give specific, favourable tax treatment to founders and executive management teams of young companies or startups to help boost the economy, and I think this is a great example for New Zealand to follow. Just look at how many successful entrepreneurs and startups are coming out of those two countries alone.

What advice would you have for companies considering instituting these kinds of arrangements with their employees?

Before giving options to employees, think about what your overall objectives are with the company and how best to incentivise those staff. Sales people, for example, generally want benefits immediately in terms of commission on sales, but others may be incentivised by the long game that options usually imply.

Talk to a founder who has done it before, get good legal advice from someone who has drafted an employee stock ownership plan before, and make sure your accountant can give you a good heads up on how to do it without killing your employees in the current tax year!

A good model from a high-tech startup perspective is to allocate roughly 10 per cent of your share pool for incentivising staff throughout the lifetime of the company. This gives a good balance of founder equity and staff incentives. If your company takes on outside investment often a similar-sized pool will be set aside again in each investment round to help reduce the dilution for earlier options holders, and to incentivise future hires.

Another consideration is how employees can trade those shares for cash. Companies that will list publically or get acquired generally have a buyer for shares so your employees get some tangible benefit. But for private companies or service companies with no real market for shares, you need to think carefully how an option-shareholder could realise the same benefit - and perhaps in this instance other ways of incentivising staff may be more appropriate.

Coming up in Small Business: Do you need a business plan? How do you go about putting one together and what impact can it have on your operation? If you've got an interesting experience with business planning to share, drop me a note: nzhsmallbusiness@gmail.com