Managing Employee Performance and Reward Concepts, Practices, Strategies 2nd edition

1. Managing Employee Performance and Reward Concepts, Practices, Strategies 2nd edition

2. Employee share ownership plans • Share bonus plans • Share purchase plans • Share option plans • Employee share plans in Australia • How does employee share ownership work? • How well does it work? • Share plan design and administration

3. Share bonus (or grant) plans • Shares fully paid for by company • Frequently in lieu of additional cash remuneration • May be rolled into retirement fund/trust • Employee receives regular dividends, typically fully franked (i.e. tax-paid) • Vested shares carry full shareholder voting rights • May be ‘restricted’: • Non-vest/holding period (= ‘golden handcuff’) • Performance hurdle/s • Forfeiture • Tax advantages depending on tax law

4. Share purchase plans • Employee pays for shares in part or full (and remains liable for purchase amount irrespective of subsequent movements in share price) • Purchase price is typically discounted (i.e. price is set below prevailing market rate) • Purchase facilitated by low-interest or interest-free loan to each employee (FBT exempt to employer in Australia) • Loan principal and any interest owing commonly repaid by means of pay deductions or firm-operated savings/salary sacrifice plan and/or from dividend entitlements • Shares held in trust during purchase period, with ownership vesting progressively as purchase is paid off • Employee liable for income tax on dividends received

5. Share bonus and purchase plans Advantages: • Long-term effect compared to cash • Encourage an ‘ownership’ mentality • Encourage long-term commitment and membership behaviour • Support high involvement • Share purchase by employees can be a source of additional capital • Share ownership by employees can prevent hostile takeover • Can serve as a convenient means of accumulating retirement funds • Tax advantages • Can be used to confer equity to employees in firms that do not issue traded shares

6. Share bonus and purchase plans Disadvantages: • Financial rewards (share price and dividends) linked only loosely to employee effort and performance • Employee dissatisfaction and demotivation if the company share price falls or fails to appreciate • Share purchase plans expose employees to considerable financial risk and loss of equity • Requires ‘open book’ management, which may expose management to greater scrutiny • May need to change management system to make it more participative and open • Costly to administer

7. Share option plans Fixed price option plans: • Previously confined to executives; now commonly available to managers and professionals • Employees granted an entitlement to purchase a specified number of restricted shares in the company at a specified (‘strike’) price at a specified future ‘exercise’ date (typically the third, fourth or fifth anniversary of the option grant date) • No ownership until option to buy is exercised • Strike price is typically the share price prevailing at the time the option is granted • Many option plans now have a ‘performance hurdle’ requirement

8. How do share option plans work? At the grant date: 1 July 2012 • The company share price is $10.00 per share • Option terms: each eligible employee may purchase up to 1,000 shares in the company at $10 per share no earlier than 1 July 2015 (= vesting date) and no later than 1 July 2017, at which time the option to buy lapses • Share purchase is self-funded • No performance hurdle restriction

9. Price scenario 1: options ‘in the money’ Prevailing share price is $15.00 Price scenario 2: options ‘underwater’ Prevailing share price is $8.00 • Employee may either do nothing or exercise option to buy some or all of the 1,000 shares at $10 per share • If the employee thinks the company’s share price has peaked they may decide to exercise the full option and sell the 1,000 shares immediately at a pre-tax profit of $5 per share • If the employee expects a further rise in the share price, they may decide not to exercise the option just now (given that this will involve an opportunity cost and that the option to buy still has two years to run) • The employee does nothing in the short-term but decides to ‘wait and see’ what happens to the share price over the course of the following two years How do share option plans work? At the grant date: 1 July 2012

10. Employee share option plans Advantages: • No up-front costs to the employee (though firm must expense against profit) • No absolute ‘downside’ risk to employees • Allows employees to defer liability for capital gains and income tax • Substitute for cash in start-ups and bull markets (e.g. Microsoft’s 10,000 millionaires) • Alignment with shareholder interests; ‘ownership’ • Higher staff retention (‘golden handcuff’)

11. Employee share option plans Disadvantages: • Encourage speculative behaviour; share ownership may be very short-term • Dilution • New option grants are a ‘cost’ to the organisation and should be ‘expensed’ against revenue

12. New option grant valuation • Current option holdings do constitute potential future income and an estimated ‘fair value’ should therefore be factored into annual total remuneration • New option grants are also a cost to the firm. Options granted generally have an expected costto the firm of 30–40% of the fair market value • ‘Present value’/grant date approach takes the projected future value of new option grants and discounts it to a present value in order to estimate the level of annual total remuneration • Most widely used approach to estimating present value is the Black-Scholes model, which takes account of: • Strike price • Projected price of an underlying security • Share price volatility • Risk-free rate of return • Expected dividend yield • Term of grant • Where a performance hurdle applies, the probability that this will be met

13. Recent variants on option plans • Premium priced options = strike price set above share price at grant date (= performance hurdle) • Zero exercise price options (ZEPOs) = deferred share grants with performance hurdles attached. Also called ‘performance shares’ • ‘Share appreciation rights’ – plans that reward for both share price movement and dividend stream

14. Recent variants on option plans Source: John Egan Associates, Sydney. Reproduced with permission.

15. How does share ownership influence employee attitudes and behaviour? Incentive effect: • Dividends and share price appreciation reinforce extrinsic motivation and task behaviour Ownership effect: • Ownership mentality heightens organisational commitment, membership behaviour and organisational citizenship behaviour • Equity ownership reduces ‘them and us’ mentality and industrial conflict

16. How does share ownership influence employee attitudes and behaviour? Involvement/participation effect • Involvement in decision-making may enhance feelings of trust, efficacy and job satisfaction, and consequently organisational citizenship behaviour • Participation heightens employee understanding of organisational finances, cf. ‘open book management’ Integration effect • May facilitate ‘shared fate’ mentality • Increased alignment between individual organisational goals may facilitate sharper performance focus, cf. ‘line of sight’ • Increased sense of peer interdependence, which may lead to greater peer pressure and consequently stronger motivation to perform

17. Requirements for employee share plan effectiveness • Top management support for plan • Extensive communication about the nature of the plan and company finances • A high level of employee eligibility • A high proportion of employees who actually own shares • Eligibility for new hires as well as existing employees • Employees owning a high proportion of overall company equity • Participative development of the ESOP itself • Accompanied by a meaningful employee involvement program • Favourable economic climate and share market • Limited employee exposure to downside risk/loss