SESSION 2: FAMILY BUSINESS AND REMUNERATION. Josh Day, CTA PwC VIC Family Business Day Tuesday 16 th August, 2016 Fenix Events

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1 SESSION 2: FAMILY BUSINESS AND REMUNERATION Josh Day, CTA PwC 2016 VIC Family Business Day Tuesday 16 th August, 2016 Fenix Events Welcome & Introduction Family businesses are unique and as such require a different approach when providing reward and equity consulting and advisory services. 1

2 The Family Businesses of today Issues Succession planning and recruiting candidates external to the family group Balancing the requirements of the family members whilst meeting the requirements of the business Finding a suitable candidate that fits in with the family Ability to find comparable roles in which to use as a benchmark Lack of publicly available data The challenges associated with incentivizing individuals and the issue of equity Case study Company A (Retail sector) Example of some of the main responsibilities of the role to be benchmarked: Develop and implement policies and strategies toward the overall promotion and protection of the family unit and achievement of long-term business objectives; Prepare budgets and forecasts for approval; Coordinate the activities between the business and the family office ensuring appropriate communication between them; May undertake responsibility for some, or all, of accounting, financial or other specialist operations; Ensure ethical management of the business and the application of adequate internal controls; Provide advice to the CEO on acquisitions, divestments, performance, growth opportunities, risk management as and when required. 2

3 Case study (cont.) Based on responsibilities and discussions the closest position matches: CFO COO CIO Benchmarking process: Forming a suitable peer group to use as a benchmark; Data collection for the various roles that reflect the key activities undertaken; Analysis of data; Preparation of report to show suitable remuneration range; Desired reward mix (ie the split between fixed remuneration, STI and LTI). Long Term Incentive Considerations Design Consideration Quantum offered Eligibility Termination Provisions Exit Event Thoughts We look forward to assisting in determining the appropriate allocation amount Determine the target and maximum LTI opportunity for participants. This should be determined in reference to: How the executive s fixed remuneration level compares to market; The executive s current expected LTI (where already employed by the company); LTI opportunities in peer companies. There is an increasing trend over the past 2 to 3 years for companies to limit LTI eligibility to those individuals who have the greatest ability to influence organisational performance or strategic direction. This is because LTI hurdles are typically company-wide metrics and are beyond the control of employees below the executive leadership group. Work through what occurs when LTI participants are a good leaver vs bad leaver We would like to work through what occurs on full exit or partial exit for participants. We note that to maximise value for potential acquirers having a good LTI in place that ensures key executive retention, but also offers flexibility is paramount. 3

4 Market Practice ASX 100 Market Practice in Australia immediately prior to the FY15 legislation changes in the ASX 100 Performance Rights and Shares 3% Performance Shares 3% Options and Shares 4% Loan - based Shares 3% Cash and other 6% Options 6% Performance Rights and Options 10% Performance Rights 65% Long Term Incentive Alternatives Phantom Share Plan Rights Plan Option Plan Loan Funded Share Plan Start-up Option Plan It is most important to determine what is the most appropriate award type for your business Businesses that are not expecting significant growth should look at awards that grant share value up front (Rights Plan and Phantom Share Plan) Business that are expecting significant growth should look at leveraged awards (Option Plan, Loan Funded Share Plan and Phantom Share Plan) 4

5 Phantom Share Plan By delivering the award as cash it is administratively simple and very flexible with how the award is calculated as there are no restrictions as opposed to delivering an equity based LTI The downside of delivering an award in cash is that it taxes the employee at their marginal rate. Additionally there are various employer on costs (i.e. Payroll tax, WorkCover etc.) as the payment is essentially just a cash bonus paid as salary subject to PAYG withholding. There are benefits to structuring the award as equity as it usually has reduced or no employer on costs and it may be possible for the employees to receive concessional tax treatment via Capital Gains Tax ( CGT ) or tax deferral on the award via taxation under Division 83A of the ITAA 1997 If the award is an equity instrument and taxed under CGT any gain that the equity holder receives on disposal of their asset will receive a 50% discount where equity has been held for more than 12 months Rights Plan Employees are granted a right to acquire a share in the Company in the future point The right has no exercise price, and can only be exercised by the employee once time and / or performance-based vesting conditions have been achieved As there is no exercise price payable, fewer rights needs to be granted than options rough ratio is 1:4 to deliver the same expected value If the vesting conditions are not achieved, the rights will lapse Plan can be designed so that rights can be sold / transferred for market value consideration, instead of being exercised Employees do not have dividend or voting rights until the rights are exercised into shares Reward Share price at date of exercise Share price at grant Right can be deferred beyond the date of grant. The deferred taxing point is the earliest of, when there is: - exercise of the Right; and - no condition genuinely preventing the employee from exercise the right; and - no real risk of forfeiture on the shares which would be acquired on exercise of the right; and - no condition genuinely preventing the employee from disposing of the share acquired on exercise of the right - cessation of employment; or - 15 years Tax Treatment General Overview The taxable amount will generally be equal to the market value of the share, with this amount taxable as ordinary income. Any further growth in value of the shares will then be taxable under the CGT rules 5

6 Rights Plan (Cont.) Advantages The taxing point can be deferred for a maximum of 7 years No shares need to be delivered until the performance / vesting conditions are met The company can use either on-market or new issue shares The inherent value in the right i.e. it cannot go out of the money like an option, provides greater perceived value and stronger retention value As there is no exercise price, the reward value will always be equal to the current share price Less leveraged reward providing relatively higher returns at low moderate share price growth (compared to options) Disadvantages No dividend / voting rights until the performance rights are exercised. Therefore, there is no perceived tangible benefit to employees during the vesting period No tangible ownership of the share until the exercise date, only a right. Therefore it may not deliver the ownership mentality the company is seeking to create The company receives no capital contribution for the issue of the shares. It pays for the purchase / issue of shares attached to exercised rights Less leveraged reward providing relatively lower rewards at high share price growth (compared to options) Option Plan A right to acquire shares in the company in the future Options can only be exercised once the time and / or performance-based vesting conditions have been achieved Individuals must pay an exercise price to exercise the options (generally equal to the market value of the underlying shares at the date of grant) Plan can be designed so that options can be sold / transferred for market value consideration, instead of being exercised If vesting conditions are not achieved, the options will lapse No dividend or voting rights until the options are exercised and shares created / acquired. Reward Share price at date of exercise Exercise price Version A Premium priced Option Exercise price is greater than the share price at grant Premium priced options are a viable equity alternative for start up companies or where significant share price growth is expected This equity vehicle is not considered an employee share scheme as at the exercise price is at a premium, therefore only CGT is due upon sale Tax Treatment General Overview Right can be deferred beyond the date of grant. The deferred taxing point is the earliest of, when there is: - exercise of the Right; and - no condition genuinely preventing the employee from exercise the right; and - no real risk of forfeiture on the shares which would be acquired on exercise of the right; and - no condition genuinely preventing the employee from disposing of the share acquired on exercise of the right - cessation of employment; or - 15 years The taxable amount will generally be equal to the market value of the share, with this amount taxable as ordinary income. Any further growth in value of the shares will then be taxable under the CGT rules 6

7 Option Plan (cont.) Advantages The Australian taxing point can be deferred for a maximum of 7 years No shares need to be delivered until vesting conditions are met (can be tied to a liquidity event e.g. trade sale / IPO, etc.) The company can use either on-market or new issue shares Company receives a capital contribution for the shares (the exercise price paid by employee) High reward pay-off, provided there is substantial growth in share price Disadvantages No longer any ability to elect to be taxed at grant (unless falls outside the Australian Employee Share Scheme Rules) In most plans likely Australian taxing point is vesting rather than exercise Can be scenarios where employees subject to Australian tax on under-water options No tangible ownership of shares until the option is exercised, only a right. Therefore it may not deliver the ownership mentality the company is seeking to create Can deliver no reward value where the share price falls below the exercise price No dividend / voting rights until the options are exercised. Therefore, no perceived benefit to employees during the vesting period Higher dilution (in terms of new share issues) when compared to share plans or performance rights plans Loan funded share plan Participants are offered shares at their market value The company provides the employee with an interest-free loan to acquire the shares The loan is limited recourse such that the employees obligation to repay is the lesser of the loan balance or the shares market value provided protection should the share price decrease The after-tax value of dividends are typically used to pay down the loan Vesting is typically dependent on time-based criteria although performance criteria can be applied A trust is typically used to hold the shares to give effect to the required restrictions. It also enables recycling of forfeited shares. As the plan is not an employee share plan within the terms of the tax legislation, the 75% rule does not apply Reward Share price at date of sale Loan balance Employee share scheme rules do not apply provided the shares are purchased at market value. Taxing point typically only triggered on sale of the shares CGT is payable on sale of the shares less the consideration paid to acquire them (ie the loan). Provided shares held for 12 months or more only 50% of the gain made may be taxable. Other taxes Tax Treatment General Overview No FBT is payable on the interest-free loan if there is a dividend yield or reasonable expectation that a dividend will be payable in the future The limited recourse feature of the loan requires careful structuring to mitigate exposure to any debt waiver FBT rules 7

8 Loan funded share plan (cont.) Advantages Provided acquired at market value not subject to the employee share scheme tax rules. Economic effect is the same as an option with the same advantages and disadvantages. Employees can receive dividend / voting rights. Immediate share ownership. CGT is applicable to any growth in the share value over the initial market value (i.e. there is no tax under the employee share scheme rules). Provided shares held for 12 months or more can take advantage of the 50% CGT discount concession. Disadvantages A loan agreement is required. Complicated and costly to set-up and administer. The loan appears as an asset on the company s balance sheet. Opportunity cost of the use of interest-free loans and bad debt right offs where limited recourse feature is utilised. Possible FBT and Debt forgiveness tax risks. An uncommon plan for listed companies Still not well accepted by shareholders Comparison of Plans Option Plan Loan Plan Performance Rights Business objectives suited for High growth focused, administratively simple. High growth focused, administratively simple Value focused, administratively simple. Perceived employee benefit and retention impact ultimately can acquire a share no dividend until exercise (may not be relevant) see below for employee tax treatment must fund exercise price but can be done via cashless exercise acquire shares up front dividends from grant date see below for employee tax treatment must repay loan but can be done at share sale ultimately can acquire a share no dividend until exercise (may not be relevant) see below for employee tax treatment no exercise price Efficient use of Equity More dilutive More dilutive Least dillutive Ability to operate within Employee Share Trust Corporate tax efficient Accounting cost Yes No Yes Yes could claim a corporate tax deduction for contributions to the trust to fund share purchases deductibility in the year the contribution is made Fair value expensed to P&L over vesting period No deduction possible As per Option Plan Yes could claim a corporate tax deduction for contributions to the trust to fund share purchases deductibility in the year the contribution is made Fair value expensed to P&L over vesting period Corporate Governance / shareholder view Should be well accepted provided subject to appropriate vesting conditions and grant sizes are reasonable Well accepted provided subject to appropriate vesting condition Should be well accepted provided subject to appropriate vesting conditions and grant sizes are reasonable Easy to cancel unvested equities Simple - Options that fail to vest just lapse More complex - Shares need to be cancelled or bought back Simple - Options that fail to vest just lapse 8

9 Comparison of Plans Option Plan Loan Plan Performance Rights Share price at grant $1.00 $1.00 $1.00 Instrument Valuation for accounting purposes $ $ $ Value of Grant $100,000 $100,000 $100,000 Example number of instruments granted 392, , ,000 $100,000.00/$ $100,000.00/$ $100,000.00/$ Exercise price (if applicable) $1.00 N/A $0.00 Hypothetical share price at vest Total economic value received by executive (net of exercise price where applicable) Low growth: $1.10 Low growth: $1.10 Low growth: $1.10 High growth: $2.00 High growth: $2.00 High growth: $2.00 Low growth: Low growth: Low growth: 392,465 x $ $392, exercise price = $39, delivered in value to the executive 392,465 x $ $392, loan value = $39, delivered in value to the executive 100,000 x $1.10 = $110, delivered in value to the executive High growth: High growth: High growth: 392,465 x $ $392, exercise price = 392,465 x $ $392, loan value = $392, delivered in value to the executive $392, delivered in value to the executive 100,000 x $2.00 = $200, delivered in value to the executive Shares acquired (after exercise price or loan has been paid where applicable) 392,465 shares will be acquired 392,465 shares will be acquired 100,000 shares will be acquired Employee tax treatment Gains treated at Marginal Rates when employee exercises their Option Gains treated on CGT account and provided shares held for 12 months eligible for 50% discount Gains treated at Marginal Rates when employee exercises their Performance Right After tax value received by executive Low growth: $39, $19, = $20, after tax proceeds High growth: $392, $192, = $200, after tax proceeds Low growth: $39, $9, = $29, after tax proceeds High growth: $392, $96, = $296, after tax proceeds Low growth: $110,000 - $53,900 = $56,100 after tax proceeds High growth: $200,000 - $98,000 = $102,000 after tax proceeds Start-up Option Plan A Start-up Option Plan is basically just an Option Plan, but it is designed to meet the general and specific conditions set out in the start-up rules in order to access the tax concessions available for start-up companies. The changes to the ESS legislation that came into effect 1 July 2015 improved the concessions eligible to start-up companies. These improvements included the ability for participants of plans under the start-up rules to defer tax until the sale of the shares with the gain subject to CGT. In order to defer tax until disposal, the plan must meet the following criteria: 9

10 Start-up Option Plan (cont.) General requirements The shares of the company is not listed on any approved stock exchange at the end of the previous year The entity must be incorporated for less than 10 years prior to the end of the entity s previous year of income Aggregated turnover of the entity is $50 million or less for the income year prior to the year of grant The exercise price for the option is at least equal to its market value when the participant acquires it The entity is an Australian resident Start-up Option Plan (cont.) Specific requirements All shares available under the Option plan are ordinary shares Shares are not able to be disposed of before the earlier of 3 years from grant date No participant, immediately after acquiring their options, will beneficially hold more than 10% of the shares of the company or are in a position to cast more than 10% of the votes in the company 10

11 Start-up Option Plan Tax Details Event Tax implications for Participants Tax implications for Company At Grant There are no tax implications for Participants when the Options are granted. There are no tax implications for the Company when the Options are granted. At vest There are no tax implications for Participants at vesting. There are no tax implications for the Company when the Options vest. At exercise On disposal To exercise the Options, Participants will be required to pay the exercise price. There are no tax implications for Participants when the Options are exercised into Shares. On disposal, should the Participant realise a capital gain, this gain (after offsetting any capital losses) will be taxed at their marginal tax rate. A 50% discount will be available to the Participants who have held their Options for more than 12 months (the conversion into Shares will not effect the timing of the 12 months). The Company will issue the respective number of shares to the participant. There are no tax implications for the Company when Participants exercise their Options into shares. There are no tax implications for the Company when the Participant sells their shares. For more information.. Please contact: Josh Day Director, Remuneration Consulting T: E: josh.day@pwc.com 11

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