Employee share schemes - loan to purchase share plan guide

Employee share schemes are an effective way for companies to offer their employees a stake in the company's success while also providing a means for employees to build long-term wealth. 

In New Zealand, employee share schemes are regulated under the Financial Markets Conduct Act 2013 and the Financial Markets Conduct Regulations 2014. In Australia, employee share schemes are regulated by The Corporations Act 2001.

In this guide, we look at how 'loan-to-purchase' plans operate, how shares are offered, repayments are made and what employees can expect.

The loan

As the name suggests, in a loan-to-purchase scheme, employees are provided with a loan from their employer (or sometimes the parent company of the employer) to purchase an allotted number of shares. This allows employees to acquire shares without a large upfront cost to the employee, which is ideal for employees who may not have access to the required funds due to a large student loan, mortgage and high inflation.

A loan-to-purchase scheme typically has a favourable interest rate in order to entice participation. Repayments of the loan can be made in a variety of ways, including:

• via the employee’s salary or via a salary sacrifice;  
• any dividends the employee receives from the company; 
• any bonus payments received by the employee; and
• voluntary repayments by the employee.

Over time, as the loan is repaid to the company, the employee will own the shares ‘freehold’ and benefit from any dividends paid on their shareholding. They will also be able to sell their shares for profit in the future.

Offer documents (the paperwork)

The key documents commonly used for offers under loan-to-purchase schemes include

• A set of scheme rules which set out how the scheme is to be operated and managed
• An offer letter or invitation letter, which includes the number of shares being offered, the acquisition price and any other terms associated with the offer
• In some situations, the company may agree to apply a discount to the price of the offered shares, which will mean a smaller loan for the employee and will allow them to be ‘in the money’ from day one. It is worth noting that this may mean that the employee is liable to pay tax on this benefitA loan agreement will outline the terms of the loan, such as repayment terms, the interest rate, default and any security for the loan. This document will also outline who the loan is being issued by, either the company or the designated financial institution (usually the company’s bank)
• An Employee Share Scheme Trust Deed may also be in place, which allows the shares to be held beneficially on the employee’s behalf within a trust or nominee structure.

Importantly, a number of specific requirements from the Financial Markets Conduct Act 2013 and Financial Markets Conduct Regulations 2014 in New Zealand and The Corporations Act 2001 in Australia need to be incorporated into the offer documents. Professional legal advice should be sought when creating these offer documents to ensure that the documents are fully compliant.

Share ownership (who holds the shares)

In the majority of cases, the shares granted to an employee under a loan-to-purchase scheme will be held by a trust on behalf of the employee. The employee will therefore hold the “beneficial interest” in the shares (also known as an “equitable interest”). This means they will have certain rights to the shares, but the formal legal title to the shares will be in the trustee’s name.

There are several reasons for this, including:

• It makes it easier to administratively recover an employee’s beneficial interest in the scheme if and when they leave the business
• It can allow the trustee to control the voting and approvals in respect of the shares
• It can allow the participants in the scheme, and their holdings in the scheme, to remain confidential

It means there will be fewer total shareholders on the share register, as only the trustee would be listed as the holder of the shares on the share register. This can be helpful if the issuer does not want to become a “Code Company” under the Takeovers Code in either New Zealand or Australia; or become subject to financial statement and audit requirements.

‍Dividend distributions

The most common method for loan-funded shares to be repaid is through a dividend distribution.

• Because the shares are held by the employee (albeit beneficially), if the company is actively paying a dividend then the employee may be eligible for a distribution payment
• If a loan is yet to be repaid, dividend payments are often automatically applied to pay the loan back over time in line with the Scheme Rules
• In what is commonly referred to as a dividend split, the company may outline that the total dividend amount that an employee-shareholder is eligible to receive is split in two payments, one portion that is received in a cash payment (paid to the employee) and the other portion that is automatically applied to the loan amount
• Once the loan is paid back, employees will be able to receive any dividends paid in cash

Interest

Whether the loan issued to an employee to purchase shares attracts interest or not is usually decided by the company in consultation with its tax and financial advisers.

You can often see a relatively low interest rate, and even sometimes a zero interest rate, in order to encourage participation in the scheme.  Specialist advice should be sought on the interest rate to be applied in order to ensure there are no negative consequences to using the desired rate.

Vesting (AKA reverse vesting)

Some schemes may require employees to be subject to vesting requirements (often called reverse-vesting) as part of their participation. This means that employees must satisfy certain conditions, milestones or KPIs, such as completing a specified period of service before they are entitled to certain ownership rights in the scheme.

• For example, if an employee is granted 1,000 loan-funded shares in the company that they work for, they may have 25% (250 shares) vest each year
• The vesting will typically relate to the number of shares that are eligible to be paid dividends on
• Over time, as more shares vest, they will receive a larger dividend and will be able to pay off their loan exponentially.

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These arrangements can have significant negative tax implications for the employee. Therefore, they should be used with caution and only after obtaining specialist tax advice on the proposed vesting arrangements.

‍What happens if an employee leaves the company

If an employee is no longer employed or contracted by the company, they are considered a leaver. Leavers will, in most cases, be required to sell their shares (or beneficial interests) back to the company (or trustee). The repurchase price will usually be at the fair market value (FMV) of the shares at the time the employee ceases to be employed. Sometimes, the price can be lower depending on the manner of the employee’s exit (such as in a bad leaver or early leaver type scenario).

Any outstanding loan amounts will be deducted from the total repurchase price.

In some cases, a company will allow the employee to hold the shares that have been repaid, and will ‘claw-back’ the unpaid shares, and subsequently cancel the outstanding loan amount.

Risks and considerations

• Employees are responsible for repaying the loan used to purchase shares, regardless of the performance of the business and any returns received on the shares
• Employee share schemes may have significant tax implications for both employees and employers, and participants should seek specialist advice from a tax professional to understand their obligations
• Investing in companies carries inherent risks, including the potential for loss of capital if the value of the shares declines

Businesses that favour loan to purchase schemes

Due to the fact that the loan that funds the share purchase for employees is typically repaid by dividends, businesses that use this structure of scheme are almost always profit-making and actively distribute profits to shareholders. Another characteristic of businesses that use this type of scheme is that their industries have highly skilled employees who are hard to attract and retain. 

It can also suit senior managers in businesses that have salaries of a level that will allow them to pay down the loan.

Conclusion

Having a clear pathway to ownership is a powerful way for companies to attract top-tier talent and retain employees for longer. Industries ranging from engineering to healthcare, manufacturing, construction, and professional services utilise loan-to-purchase schemes as part of their overall compensation and benefits packages. 

This type of employee share scheme can be complex. So, it’s vital that employees understand the mechanisms that allow the loan to be refunded and see the financial benefits from future capital gain increases and cash dividend payments before entering into an agreement.

Having a dedicated portal for employees to track their shareholding, loan amount, down payments and any interest accrued will allow them to be more engaged owners.

‍Chat with the Orchestra team about how Orchestra’s equity management software can help support your employee share scheme. Request a free demo here.

Thanks to Nick Kovacevich - Partner at Couch Harlowe Kovacevich for contributing to this article.

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Disclaimer: This article is a brief overview of the key points, but is not to be taken as legal, financial or tax advice. We encourage you to discuss specific questions with specialised professional advisors.