Rise of ESOPs: Transforming business through employee ownership

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The rise and impact of ESOPs

The adoption of ESOPs has surged in recent years, impacting over 211,000 employees since 2019, including historically disadvantaged persons (HDPs). According to the Department of Trade, Industry and Competition, beneficiaries have received dividend payments totalling approximately R3.3bn through ESOPs, with around 98 ESOPs established and 27 in process since 2023.

But what exactly are ESOPs and why have they become increasingly popular?

Understanding ESOPs and their types

In essence, an ESOP is a programme initiated by a business that offers employees the opportunity to acquire shares or a similar ownership interest in the business they work for. Employees “owning” part of the business they work for is a powerful incentive aligner, encouraging collaboration and rewarding employees based on “their” business's success. Beyond financial rewards, ESOPs can help attract and retain top talent, align internal values and interests, and meet B-BBEE requirements, all while nurturing a sense of belonging among employees.

ESOPs also feature quite strongly in merger conditions imposed by the Competition Commission, solidified with the publication of the public interest guidelines relating to merger control in March 2024. Amid these advantages, ESOPs can be costly and complex to implement and administer, given the different layers of regulation that govern their operation.

There are different types of ESOPs, each with unique characteristics:

• Restricted share scheme - Shares are granted to employees either for free or sold to them at a discount, with ownership immediately transferred to the employees, typically subject to conditions.
• Share purchase plan - Employees are allowed to purchase shares at a discounted price, with payment made through payroll. Arguably the simplest model, share transfer occurs when the shares have been paid for in full.
• Option scheme - A contractual arrangement between the company and employees where employees have the right to buy shares at a predetermined price.
• Phantom scheme - Employees receive “phantom” shares that mimic real share value movements but do not include actual shares. This scheme provides financial benefits akin to share ownership.

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Direct v indirect ownership

In addition to the chosen type, ESOPs either fall into a direct or indirect ownership bucket, which bleeds into the participation model and ownership structure. Ownership structure can be broken down into employees who may have direct ownership in the company, with shares registered in their own names or the participation rights track directly in the company or where employee share ownership is expressed through a vehicle created for that purpose.

As so far discussed, ESOPs are quite flexible, offering employers a variety of options for participation. Critically, how an employee enters into an ESOP, which either happens through contractual rights or as a benefit, has a material bearing on their classification as a participant.

If an employee participates in an ESOP as part of a company policy or through ESOP rules separate from their contract of employment, it may be considered an employment benefit. As a benefit, it's worthwhile to remember that the definition of an unfair labour practice is "any unfair act or omission that arises between an employer and an employee involving unfair conduct by the employer relating to the provision of benefits to an employee".

In our experience, ESOPs with many participating employees in South Africa are typically structured as a trust or Special Purpose Vehicle (SPV) that holds the shares on behalf of employees (ie indirect ownership) versus employees holding shares directly. In such a case, the rules of who may participate and when benefits are awarded are generally set out in policy documents.

The key aspect that determines who participates in an ESOP is if the parameters or rules are defined in a way that is fair, rational, consistent and justifiable, whether participating employees are top management, all employees, or Black ownership for the purposes of B-BBEE. Qualifying criteria must take into consideration the deeming provisions of the Labour Relations Act, which creates complexity around the inclusion of temporary employment service employees, contract workers, and part-time workers. There are also good and bad leaver provisions that require consideration, which have an overall impact on the employee-employer relationship.

ESOPs and B-BBEE compliance

An area where ESOPs play an important role in South Africa is in respect of the B-BBEE Act as ESOPs have real consequences upon B-BBEE ownership scores where such schemes are implemented for this specific purpose. An ESOP must have specific minimum qualification criteria that need to be met to qualify as B-BBEE ownership.

Role of the Competition Commission in the rise of ESOPs

Mark Garden, a competition law expert and partner at Webber Wentzel, further adds that an amendment to Section 12A of the Competition Act in 2019 introduced additional public interest considerations designed to facilitate the spread of ownership by workers and HDPs in the South African economy. This amendment has led to a notable increase in the adoption and implementation of ESOPs specifically focusing on ensuring that mergers do not dilute HDP or worker ownership.

The Competition Commission's Public Interest Guidelines, published in mid-2024, clarify that any proposed ESOP must compensate for ownership dilution by matching the percentage by which HDP or worker ownership is reduced. Although, in practice, the approach tends to be more nuanced, ESOPs are routinely endorsed by the Commission as an effective remedy.

Navigating regulatory complexities

Designing and implementing an ESOP is a complex process subject to numerous regulations. A well-thought-out ESOP roadmap is essential, especially when considering the winding-down of a scheme, which must comply with the procedural and substantive fairness mandated by the Labour Relations Act.

ESOPs can be a highly effective tool to achieve strategic company objectives but given their associated complexities and the regulations that govern their operation, it is advised to seek sound legal advice so that a company ESOP provides maximum benefit to the organisation at large.