Employee share ownership in an innovative economy (1)

Innovation and entrepreneurship look set to be the business buzzwords of the decade. Seldom a week goes by without something reinforcing the notion that we must foster these qualities to achieve a prosperous future and halt our slide down the OECD rankings. Official recognition has been given to this by the Prime Minister's Growing an Innovative New Zealand report released earlier this year.

Employee share ownership has an important role to play here.

There can be no doubt that a key building block of the innovative economy is the attraction, retention and motivation of skilled individuals. As the Prime Minister's report states "as well as continuing to develop better core skills we must grow, attract and retain people with the talent to be innovators". In seeking these individuals, we are forced to operate in an environment where intense competition takes place on a global basis.

New Zealand's lifestyle and environment provides us with a competitive advantage over many of our competitors in this area. However, our position well down in the OECD per capita income rankings is a very significant disadvantage. Simply put, it is very difficult for our businesses to pay employees as much as our competitors in richer countries. As the Chair of AgResearch stated in the latest Annual Report, the "retention of scientific skills is likely to be a growing problem" in New Zealand.

Employee share ownership offers a tool to mitigate this disadvantage. This is well understood by some of our competitors, such as Singapore which has established a tax-favoured Entrepreneurial Employee Stock Option Scheme (more on that in article 2), the United Kingdom, Ireland and the US. Facilitating employee share schemes will provide New Zealand with a competitive advantage.

A key innovation/entrepreneurial model involves a start-up company, a great idea and dreams of becoming the next Microsoft. It is likely that the talent needed to develop and realise these dreams will only be available if given the opportunity to share in the wealth potential. In a global marketplace for talent, individuals who are not offered this opportunity will often migrate to a place where it is available. Employee share ownership is the key tool through which this wealth potential can be shared with employees.

Employee share ownership also dovetails well with another feature of entrepreneurial companies - the high rate of cash burn. Cash is more often than not in short supply during the start-up stages and this makes equity based employee rewards particularly attractive.

On the other hand, there is no doubt that the start-up business model gives rise to certain challenges in relation to share scheme design. In particular, unlike with a listed company, there will be no established market into which an employee may sell the shares acquired (although ideally the scheme will be structured to encourage employees to retain their shares). Also, despite the stellar growth possibilities, the risk profile of start-up businesses is such that it will often not be realistic for employees to invest significant amounts of their own money in shares.

Design solutions are available to deal with both of these issues. The lack of liquidity in the start-up's shares can be dealt with by designing a scheme that provides benefits only once a liquidity event occurs i.e. typically a float or a trade sale. Given that the main objective of the entrepreneur will usually be to achieve such an event, this structure neatly aligns that objective with the incentive provided to employees.

Similarly, schemes are available which provide employees with the benefits of share price increases, without requiring an initial investment or exposing the employee to risk if the company fails. This is the way in which share option schemes and their derivatives work.

There is a clear role for employee share ownership in the innovative economy. However, we have certain legal and tax rules that make it difficult to realise the full potential of this powerful tool. These rules, and the environment in competitor countries, will be commented on in the next two articles.

Mark Todd is a partner in the Auckland office of Bell Gully. In conjunction with Morel & Co, an investment bank specialising in technology companies, he has established a group interested in the development of employee share ownership in New Zealand.