5 Stages to Execute Employee Share Ownership

Introduction

This year here at Roberts Crosbie Mortensen our Commercial Team has been involved in an increasing number of transactions whereby the owners of small to medium enterprises (SMEs) are implementing succession plans to bring employees into ownership roles.

It seems that following on from Covid and the “great resignation” many business owners are now taking the positive step of implementing succession plans to retain key employees and bring them through as successors by offering them an ownership stake in the company they work in.

And remember that when we reference “SME companies” the Australian Tax Office categorises small businesses as those with an annual turnover of $10 million or less and medium businesses having a turnover of between $10 million and $250 million, so they are not necessarily that “small” and they make up the vast majority of companies doing businesses in Australia.

So if you are a SME company owner and are considering the possibility of bringing on one or more employees as shareholders/owners, then this article is for you as we discuss the steps and planning that goes into this process.

Selling Shares vs Issuing Shares

In this article when we reference “bringing on employees as owners” this is a reference to you (the company owner) selling shares in your company to your employees. The transaction is between you as a shareholder and your employee which means the sale price for the shares is paid by the employee to you as shareholder and not the company. Share sales are used when an owner wants to step back (or sell out) and extract cash or get a “pay day”.

Some succession plans might make provision for the company to issue shares to an employee(s). The transaction in that case is between the company and the employee. The issue price for the shares is paid by the employee to the company (as capital) and not you as shareholder. Share issues are generally used if the succession plan is for the growth of a company.

Stage 1 – Review Your Circumstances

As the company owner you need to assess your own personal circumstances in relation to what you want out of your business when it comes to succession.

Four key questions to consider:

1. Timing: when do you want the succession to take place? Now? In the future? Or a combination (staged)?
2. Ownership: are you looking to transfer complete ownership to your employees? Or only part?
3. Control: are you willing to give up control and step down as a decisionmaker (director)? Or do you want to relinquish some ownership but still have decision making power?
4. Money: how much do you want and when?

In conjunction with reviewing your personal circumstances you should also be reviewing your company and its business. Two key questions to ask yourself:

• What is my company currently worth?
• What are my future plans for growth, operations and management?

When you have assessed your personal and business circumstances and identified what you want from your business succession plan, then it is time to talk to your professional advisors.

Stage 2 – Engage Your Professional Advisors

It is important that you engage with your lawyer and accountant early on in the piece. No succession plan is the same and each hinge on their own particular facts, often formulated on the advice of your accountant and lawyer working together.

As such it is important that you liaise with both professionals (and that your accountant and lawyer talk with each other) as clear communication between you, your lawyer and your accountant will lead to a clear and workable succession plan that enables a smooth transition with less chance of disruption to your company’s operations.

With the assistance of your lawyer and accountant you should be looking to:

1. Identify your potential successors.
2. Prepare an Information Memorandum that will provide relevant financial and company information for disclosure to the targeted employees.
3. Map out and plan the process and documentation needed to implement your succession plan.

Lawyer

As your lawyers we will ensure that your succession process is documented correctly and that you receive the best possible advice given your circumstances. Key pieces of legal documentation and advice are discussed below under “Implementation”.

Accountant

In conjunction with legal advice and documentation, you need to know and understand the financial implications surrounding the sale of shares to your employees. Any transfer of ownership needs to suit your financial situation and be tax efficient.

Your accountant may also be an important guide when it comes to valuation and determining the value of your company (and therefore the value of the shares you are looking to sell to your employees).

Stage 3 – Approach Your Successors

Having completed the pre-assessment of your personal circumstances and formulated your succession plan with your lawyer and accountant, you then need to move on to putting the plan to the targeted employee. Most business owners will do this with face to face meetings. Important: before you meet with or disclose any information about your succession plan to an employee consider the need to have them sign a separate and binding Confidentiality Agreement (also known as a Non-Disclosure Agreement or NDA). Don’t just rely on general confidentiality provisions under any existing employment agreement.

Stage 4 – Implementation

If your employees are keen to take up your offer of ownership then your lawyer becomes instrumental in documenting the transaction.

Key documents in the implementation of a succession plan being:

Confidentiality Agreement

If (as is usual) you intend to disclose high level information such as financial performance of your company to an employee, prior to doing so you should have them employee sign a Confidentiality Agreement. Simply put, a Confidentiality Agreement places an obligation on the employee to not disclose information about your company that they receive from you to any other person such as your lawyer or accountant. A simple but important obligation.

Heads of Agreement

Often referred to as the agreement before the main agreement a Heads of Agreement is signed prior to a formal Share Sale Agreement. It allows you and your employee to agree on certain key commercial terms such as the purchase price, timing and a methodology for due diligence without binding yourselves to a deal.

Share Sale Agreement

The formal Share Sale Agreement (also referred to as the Agreement for Sale and Purchase of Shares) is a cornerstone document as it will set out the terms and conditions for the sale and purchase.

As the seller it would be usual for you and your lawyers to prepare the first draft of the agreement. Then the back-and-forth begins as to the negotiation and finalisation of its terms. When the terms of the agreement are agreed, a final copy will then be prepared, signed and exchanged after which the agreement becomes a legally binding contract.

Shareholders Agreement

The other cornerstone document when it comes to a share sale and managing your company succession plan is a Shareholders’ Agreement.

A Shareholder’s Agreement is a private contract between the owners of the company (the shareholders) setting out how the owners want the company to be run and managed. For a detailed breakdown on Shareholder’s Agreements and why every company with multiple owners should have one please see our article “Why You Need a Shareholder’s Agreement and What Should be in Them”.

When it comes company succession planning four very useful tools that you can include in your Shareholders’ Agreements are:

• A lock up: this is where an employee owner gets “locked in” for a certain time period eg a period of five (5) years. During which they cannot sell or dispose of their shares without triggering an event of default.
• Good leaver and bad leaver: the transaction is structured on the basis that the employee owner enters into an Executive Employment Agreement and that if their employment with the Company is terminated:
  • On “good leaver grounds”, for example where they resign their employment with the blessing of the other owners or are forced to resign for medical reasons, then they must sell their shares in the Company but they receive 100% of the value of their shares; or
  • On “bad leaver grounds”, for example where their employment with the Company is terminated on grounds for cause (they are fired), then they are forced to sell their shares in the Company and they receive a reduced value for their shares, say only 80% of the value of their shares.
• Drag along rights: gives the original owner (usually if they are still the majority shareholder) the right to instigate a sale of all of the Company’s shares to a third party without having to comply with pre-emptive rights (the need to offer their shares first to the other shareholders).
• Restraints: it would be usual that a set of restrictions (as to geographical area and time) be imposed on the employee shareholder to protect the goodwill of the Company.

Executive Employment Agreement

Used in conjunction with the Shareholders Agreement, an Executive Employment Agreement clearly sets out the elevated status of the employee and their roles and responsibilities. They can also be used as a fixed term employment agreement to further lock the employee in and bind them to the company for a fixed time frame.

Stage 5 – Handover

The last stage in the succession process is handover (or completion). Requirements of such will depend on the succession plan to be implemented but will generally involve:

1. Execution of the Shareholders Agreement by all parties.
2. You as owner providing the employee with a share transfer and having them registered as a shareholder of the company (and possibly as a director of the company).
3. You receiving payment from the employee for the shares you sell and transfer.

Final Word

If you would like legal advice on a succession plan for your company our commercial law team here at Roberts Legal would be more than happy to assist. Please contact Amanda Crosbie or Hamish Taylor in the first instance. And remember, our approach here at Roberts Crosbie Mortensen is to make business happen, not to get in the way.