Steve Ducat is staking his future on the first launch of a national newspaper in Britain since The Independent 20 years ago. Last December, he left his job running the finances for a £1 billion operation to join The Sportsman, a start-up venture designed to capture the explosion in sports betting. Funded by private investors like Zac and Ben Goldsmith, The Sportsman is setting out to help punters make more money off the bookies by covering all major sports, as well as minor ones like darts, which are attracting high stakes through online betting and digital TV.

The Sportsman launched at the end of March with an initial print run of 200,000 in time for the Grand National and with an eye on the World Cup, the year’s biggest betting event. Alongside Ducat as finance director, there are eight members of the publishing committee with options on up to 100,000 shares.

The initial market value for the shares agreed with the Treasury was 20p and the third round of finance recently closed at 80p. It’s expected that the company’s major backers will be looking to make an exit in three to four years. At a price of £40 million to £100 million, that would equate to shares worth between £2 and £5. Some of the shareholders are staff, ‘so if the company is a success,’ says Ducat, ‘it will be fantastic for everyone.’

Pick ‘n’ mix rewards

The prospect of such gains is powerful motivation for senior executives who are responsible for driving a business forward. For investors, the calculation is that by setting aside ten to 20 per cent of the equity, the remaining 80 to 90 per cent will become worth significantly more. Almost as importantly, this creates a powerful reason for top performers to stay until they realise the value of their holdings.

For smaller enterprises far away from the world of high finance, such share schemes can still offer a chance to recruit a calibre of executive that growing firms would not have thought possible without stumping up a high salary. As long as gross assets are worth less than £30 million, an EMI (enterprise management incentive) scheme can be set up that allows any gains on share options to be taxed as capital at ten per cent, rather than income at 40 per cent.

Nor should administering such reward schemes be too complex, says Duncan Brown, the director responsible for research and policy at the CIPD (Chartered Institute of Personnel and Development). ‘Smaller companies have always had the advantage of being able to strike deals off the cuff with executives. But they have then tended to run into trouble as the organisation grew, with executives on different incentives.

‘Off-the-shelf tools are now readily available that allow you to offer a pick ‘n’ mix of rewards using software to give you an accurate calculation of the outcome. You can use this flexibility to attract a management team of a quality that you might not normally expect to be able to afford.’

Expectations and aspirations

When working out packages for executives, with incentives in the short-, medium- and long-term, be careful about jumping to conclusions about what they want, warns Esther Carder, a partner at Willott Kingston Smith, who specialises in advising companies in creative communications.

‘Talk to executives about their aspirations. They’re not going to turn down share options, since they can just sit on them on and be quids in, but are options going to keep them in the business?

‘We recently set up a package for two key execs. One loved the options, but the other one left within a year because it turned out that what she really wanted was the cash for a new kitchen and a new car.’

Carder advises, ‘Tailor the reward to the individual. Find out what motivates them. Money, power, status, family or interesting work? Creative directors, for instance, often have no ambitions at all to be part of the management team.’

Flexible share schemes

More than 3.5 million UK employees now have shares or share options in the companies they work for. Where options work particularly well is when a company is building towards an exit or a liquidity event such as selling up, as there is clearly a buyer for the shares in prospect. Venture capitalists or private investors generally earmark ten to 20 per cent of the equity to be divided among the management team, although in deals heavily reliant on debt that proportion might rise to 50 per cent. One of the legacies of the dotcom era is that the proportion for each executive is usually open for negotiation.

When the option scheme is set up, a strike price is agreed with the Treasury to reflect the underlying value of the company. Executives then have the right to buy shares at this original price in a defined period with any gains treated as capital, not income, and taxed at ten per cent. If they leave the company, however, they forfeit the options.

For private companies with no plans to float or sell up, share options can still act as a powerful incentive, although it is important to be clear about the potential benefits for executives. One of the major drawbacks of giving shares in a private company is that there is often not a market for them. If a senior executive leaves, their shares are only of value if they can be sold on or sold back to the company. ‘You have to create an internal market for shares and you need some company money to create liquidity,’ says Graeme Nuttall, a partner who specialises in employee share plans at Field Fisher Waterhouse.

‘You could set up a company trust, so when someone retires or leaves, the trust has the resources to buy back their shares. Executives then know that there is a mechanism ready and waiting to buy their shares. Otherwise, they are dependent on the whim or liquidity of the owner.’

Investors might prefer executives to take a more direct stake in the future of the company by asking them to buy shares directly. This is less tax efficient and can be more cumbersome to administer. ‘You have to enter them into the articles of association,’ says Nuttall. ‘It can be difficult to make one size fit all. With share options, you can set the individual terms. For owners, there is tremendous flexibility in the rights that they can attach to shares. It is possible to create plans with non-voting shares or limited votes.’

For some private companies, it might be simpler to create a ‘backpocket’ option, which is only exercised when the owner decides to sell the company, or a ‘phantom’ scheme where rewards are linked to the company’s value.

As an alternative to share options, you could set up an employee trust, where a percentage of the equity is assigned to people who work for you, with dividends dispersed with salaries. In the event of the sale of the company, it would be down to the trustees to decide who benefits and to what extent.

Behaviour and performance

In designing packages for senior executives, make sure you have a clear timeframe, driving behaviour in both the short- and long-term, says Giles Capon, who leads the human capital practice at Ernst & Young.

‘The commercial motive underpinning the scheme might be that you want to get to a liquidity event such as a float or sale,’ he says, ‘but in private companies the long-term equity incentive tends to be a mechanism to retain the senior team rather than to tie performance explicitly to shareholder value.

‘Variable cash components, such as bonuses, can be a more effective way of linking the performance of the individual to the objectives of the business. They should be related to measures that really do make a difference, with a clear line of sight on each individual’s input.’

Capon aims to set up bonuses for his clients that generally form 30 per cent of an executive’s package and finance themselves when targets are outperformed. ‘Where bonuses go wrong is when they are expected,’ he says. ‘The criteria are not strict enough and they just become an additional form of salary. When not related strongly enough to the business plan, they can just become a poison pill for business owners three to four years down the line.’

Theory in practice

In five years, Rackspace has taken its sales from virtually nothing to nearly £40 million and has won a place in the top ten of The Sunday Times’ ranking of the best places to work in the UK. Alongside a culture of ‘fanatical’ customer support, which the UK web hoster has inherited from its Texan parent, Rackspace’s impressive performance relies on a simple set of quarterly signals linking the objectives of the business with the rewards for each individual.

Directors’ pay is linked to ‘economic value added’ (EVA), which is a single measure for net income after tax, less the cost of capital. ‘It encourages us to behave in two ways,’ says Dominic Monkhouse, chief executive at Rackspace in west London. ‘Do more with less and find more profitable customers.

‘It gives you a strong sense of ownership; you feel that it’s your money,’ says Monkhouse, half of whose pay depends on EVA.

‘If we have a dip then people will be unhappy, but it’s in our hands. We run the business. So, we look at the numbers weekly or even daily. The business is rewarding us to make the right decisions.’

Such bonuses are uncapped, although Rackspace does smooth out the differences. ‘If we are 220 per cent of our EVA goal, as we were in the final quarter of last year, we don’t pay out 220 per cent. We pay 120 per cent and bank the difference, so if we fall short in future, we can claw it back. Too often, bonuses are all upside and no
downside.’

People are also graded every quarter, allowing them to see how their earnings might progress if they score A, B or C. ‘No more than 25 per cent can be A and we try to find ten per cent who are a C. It’s too easy to give straight As,’ says Monkhouse, who ensures that all the rankings are discussed with individual team members.

Share options are available, but on a more limited basis than before, as Rackspace is close to breaching the ceiling at which the US authorities would require it to become a listed company. For Monkhouse, it is not a major consideration. ‘I’ve never been in a company where the options have earned me anything. So it’s a bit like the tombola at the village fete. If it happens, it would be nice.’

A guide to share schemes

There are four types of Government-approved share scheme you can offer your employees, which are:

Save As You Earn (SAYE)

An approved SAYE scheme is a savings-related scheme you can set up that must include all employees who’ve been with the company for a certain time. The scheme gives employees a right (known as a share option) to buy shares with their SAYE savings for a price that’s fixed at the start.

Employees can save up to £250 a month into the scheme out of their take-home pay. At the end of the savings contract (three to five years, or sometimes seven) employees can use the savings to buy the shares.

The interest and any bonus at the end of the savings scheme is tax-free for employees (unless it is cashed in early) and they don’t pay any income tax and national insurance contributions (NICs) on the difference between what is paid for the shares when using an option and what they’re actually worth. Income tax and NICs are due on this difference with non-approved schemes. Employees may have to pay capital gains tax (CGT) when they sell the shares, but not if the shares are put into an ISA as soon as they are exercised.

Company Share Option Plan (CSOP)

An approved CSOP scheme gives the employee a right (or option) to buy up to £30,000 worth of shares at a fixed price at a particular time. As an employer, you can choose to whom you offer the option, but employees won’t be eligible if they already own more than 25 per cent of the shares of a company that’s controlled by under five people (or by its directors).

Employees won’t pay income tax and NICs on options or when they get their shares if the scheme’s approved and you stick to the rules. Employees may have to pay CGT when they sell the shares.

Enterprise Management Incentives (EMI)

If your company has assets of up to £30 million, it can offer employees an option to buy shares worth up to £100,000 without them having to pay income tax or NICs. They may have to pay CGT when they sell the shares.

Share Incentive Plans (SIPs)

There are four different SIPS schemes:

• Free shares
• Partnership shares
• Matching shares
• Dividend shares

Employees can get shares under one or more SIPs and, if they keep them in the plan for five years, they won’t pay income tax or NICs on their value when acquired. (Employers normally have to deduct this from the value of benefits given to employees.) They also won’t pay any CGT if the shares are kept in the plan until they’re sold. If employees keep the shares after they are taken out of the plan they only pay CGT, if due, on any increase in value between when they were taken out and sold.