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Employee Benefit Trusts | Key considerations

Insight 3 June 2021

Employee Benefit Trusts | Key considerations

Employee Benefit Trusts (EBTs) are discretionary trusts often established by companies to support the operation of their employee share plans, which can be used for a number of purposes. A well-structured equity incentive arrangement operated through an EBT can deliver great value to both a company and its employees.

In addition to serving as a mechanism for delivering shares to employees, one of the benefits of establishing an EBT is to warehouse shares, generally in a tax neutral environment, and overcome any potential issues with shareholder dilution.

UK corporate governance is intrinsically linked with the guidelines set by the Investment Association (IA) and associated principles of remuneration. These principles set clear dilution limits for shareholders of companies so that in any rolling ten-year period:

  • no more than 10% of a company’s share capital can be the subject of incentive awards (outstanding and paid out) under all its share plans;
  • no more than 5% can be used for executive (discretionary, as opposed to “all-employee”) plans. Companies do need to consult and seek approval should they wish to breach these limits without the risk of being ‘red-topped’ and companies should therefore implement policies to manage the dilutive effect of newly issued
    shares, including treasury shares.

A hedging strategy should implement a set of measures designed to minimise the risk of adverse movements in the value of assets or liabilities, and it’s the latter which is linked to awards and options granted under employee share plans. A crucial consideration when implementing an employee share plan and establishing an employee benefit trust is how and when to source the shares to satisfy the options and awards made to employees.

Fulfilling a company’s future obligations under its share plans can be a complex process for share plan managers, company secretaries and finance or treasury professionals. This can be further complicated by the wide-ranging impacts volatile stock markets can have on incentive schemes. Companies are expected to apply discretion to prevent any windfall gains and some companies may face major challenges in dealing with dilution limits

Any share awards made against a backdrop of a depressed share price will require additional shares to be granted in order to satisfy the total value of the award. With the need for more shares, this will also reduce the company’s headroom. Combined with the need to conserve cash some companies may be unwilling, or unable, to market purchase all shares due to the cost and lack of distributable reserves.

Existing hedging strategies and the sourcing of shares needs to be considered to minimise the risk of adverse movements in the value of liabilities linked to awards and options granted under their employee share plans. Any effective share hedging strategy must be regularly monitored and adjusted throughout the lifecycle of the share plans. The ultimate goal is to achieve a delicate balance between the need to acquire sufficient shares in advance of exercise/vest and minimising the costs of doing so.

One way to mitigate the risks associated with potential challenges of dilution limits is to leverage opportunities to purchase shares into an EBT and hedge against future obligations to deliver shares on vest or exercise.

This is an advantage that EBTs have over the use of treasury shares, which do count towards dilution limits, and therefore provides a cost effective solution to compliance with the principles of remuneration.

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