North Sea oil and gas firms should look to tailored equity plans to incentivise staff in constrained market, says expert

New incentives may seem an unlikely priority for those faced with winding up capital projects and making significant redundancies, but the commercial reality is that these firms still need to attract, retain and motivate the best staff. For those companies with particular retention and incentivisation needs, a carefully-designed package of revised incentives could play a big part in any recovery.

At the same time, the incentives and performance targets that firms already have in place will have been overtaken by market change and may well now be inappropriate. Firms should, therefore be prepared to question their past approach to award structure and terms when looking to lock-in and motivate those tasked with ensuring that they survive - and thrive - in a fundamentally altered business environment.

Why equity incentives?

While share plans are often operated within clearly defined pre-set parameters, this does not always need to be the case. For oil and gas companies struggling with reduced cash flow, rebalancing packages towards elements that pay out – and dilute investor equity – only if and when business value recovers can be an effective means of incentivising staff below board level.

Reduced share values can also make equity awards very attractive for those who are confident that they can succeed and drive the share value back up. By the same token, employers may also find them more attractive than before share values fell. This is because any particular value that the company might want to deliver might be expected from fewer shares, if the targeted performance ought to deliver a substantial increase in the share value.

Although equity incentives can clearly also be used at board level, fully-listed companies will be restricted by their shareholder approved directors' remuneration policy. Relevant investor expectations will also come into play for all quoted companies.

Getting the structure right

Regardless of market conditions, the range of equity award types available for firms to consider depends on whether they are publicly-traded or privately held.

Listed companies (main market and AIM) should consider using one or more of:

• tax-advantaged CSOP options. The individual maximum holding of £30,000 worth of shares under option limits the use of CSOPs, although reduced share values might make this less of a restriction than before the oil price fell. The more generous tax-advantaged EMI share options are, in practice, most unlikely to be available to companies operating in these areas;
• performance share awards – also known as long-term incentive plan (LTIP) awards;
• unapproved share options;
• jointly-owned equity awards, such as 'ExSOPs' or 'JSOPs'. These offer more favourable tax treatment for the employee than performance shares and unapproved options, although the employer will not gain corporation tax relief as it could from LTIP or option awards.

Private companies should, in addition to the above, consider using one or more of:

• growth shares. These are shares with class rights designed to give a low value at acquisition – making them low cost and/or low tax cost to the employee – that will rise with increasing company value, giving the holder a significant gain from any growth in value that the company achieves. While this type of share plan can be more demanding to implement, it should be tax efficient if put in place correctly;
• nil-paid shares. These are shares which employees buy on a 'buy now pay later' basis. Like growth shares, they offer the potential benefit of tax efficiency with low initial employee costs. Unlike growth shares, nil-paid share schemes need not involve setting up and valuing a separate class, or classes, of share.

Growth shares and nil-paid shares, which listed companies generally cannot use, produce a similar outcome to jointly-owned equity. They may be preferred by private companies as they can be simpler to set up and operate.

Getting the terms and conditions right

As well as selecting the right type of equity award, a company should think carefully about the terms of awards granted during difficult market conditions. That market environment might well overturn several aspects of the former 'right approach' adopted in the company's most recent awards and perhaps for many previous awards. When there is a perception that new awards need to be made soon, a company could understandably fail to question its usual practices regarding award terms if those responsible have little awareness that things could be done differently.

Share value chosen to price options or determine number of shares awarded

Generally, the exercise price of share options and the number of shares comprised in an award will be determined by reference to the market value at grant. The same approach, broadly, should continue to apply in difficult market conditions. However, where the announcement of new leadership, restructuring or publication of a detailed recovery plan has already increased the share value, it might be worth considering the use of a lower value reflecting the pre-announcement share price. In effect, that represents the true 'starting point' for the recovery in value that award recipients are being asked to bring about.

Performance conditions

In difficult market circumstances, any performance conditions should reflect the revised strategic targets in the company's recovery plan as well as those particular strategic targets that each award recipient is most responsible to deliver. Although there have been many pleas for listed companies to make less use of non-strategic performance measures, like earnings per share or total shareholder return, these are still widely used. Difficult market conditions may give firms an opportunity to substitute strategic performance measures for these general 'favourites'.

Since the whole UK oil and gas industry has been affected by the market downturn, rather than one unlucky or badly-managed company, firms should bear in mind that the whole sector could well recover in a co-ordinated fashion as a result of some external market change. As a result, some form of comparative performance measurement should perhaps be retained alongside appropriate strategic performance conditions, to avoid rewarding executives simply for the recovery of the sector rather than of their company individually. Achieving both of these goals will require careful drafting of award terms.

Adjustment of conditions during vesting period

Although equity plans often include some scope to recalibrate performance conditions, it is generally unacceptable to 're-test' awards should the original performance conditions become impossible or fail to be met. Despite this, it may be appropriate for a corporate recovery incentive to provide greater scope for the adjustment of key strategic performance conditions if the recovery plan is overtaken by events and needs to be reconsidered. Greater flexibility is more likely to be required if future awards are to be made less frequently than would normally be the case.

It may also be especially important where some recruitment or retention awards need to be offered before a detailed recovery plan is complete. The usually strict expectation that award structure must be closely related to the share price at the time of grant can make it difficult to simply promise to make awards, on appropriate detailed terms, once the recovery plan is finalised.

Are performance conditions necessary?

While best practice dictates that equity incentives should be subject to performance conditions, in acute market conditions commercial needs may be very different. For example, firms may wish to grant new awards without any performance conditions attached where this is done purely for retention reasons.

Award frequency and quantum

Companies will usually have an established frequency for making awards. Generally, listed companies make awards every year, rather than larger awards every few years. Again, this may need to be reconsidered in light of the timescales set out in the company's recovery plan. Similarly, it may be sensible to consider partial vesting on achievement of intermediate targets at 'milestone' intervals within the main vesting period.

Vesting periods

Companies will probably have well-established normal vesting periods for their long-term incentive awards. Again, this may need to be adjusted to fit with the timescale envisaged for success in the company's recovery plan.

Leaver provisions

A different approach to leaver provisions may be required where a business wants to retain and focus key staff over the whole recovery.  Companies that would generally not be generous to 'good' leavers, or give themselves much discretion to benefit leavers in exceptional circumstances, may wish to reconsider that stance when encouraging staff to commit to a long-term recovery plan rather than seeking safer roles elsewhere.

On the other hand, the whole point of making more generous long-term retention awards is to retain staff for the whole award term and to drive delivery of the recovery plan. For that reason, while it may be sensible to offer generous terms to good leavers – albeit subject to any targets being met and on the usual vesting schedule – the company may still want to impose forfeiture of awards on voluntary early departure, and also to emphasise that point in the context of the retention purpose.

Catering for new capital, restructuring and possible takeovers

Equity incentives usually include provisions to deal with changes to share capital, group structure and control. These provisions require additional consideration where an entire industry is adjusting to change since calls for new capital, business disposals and acquisitions and market consolidation may all become more likely. Companies should therefore give careful consideration to the way in which they frame these provisions in any new schemes.

Depleted company reserves and the use of market purchase or newly-issued shares

For listed companies, reduced profitability and large exceptional costs can quickly deplete distributable reserves. Reduced reserves can make it very difficult for listed companies to go on funding the market purchase of their own shares to satisfy equity incentives. Some companies may therefore need to consider making more use of newly-issued shares than they have previously done for this purpose and whether, for those listed on the main market, this would require any shareholder approval.

Matthew Findley is a share plans expert at Pinsent Masons, the law firm behind Out-Law.com