WHY COMPANIES NEED TO SUPPORT ESOP INITIATIVES Presented by Zukile Nomafu CA (SA)

1. WHY COMPANIES NEED TO SUPPORT ESOP INITIATIVESPresented by Zukile Nomafu CA (SA) 25 July 2012

2. 1. Introduction • In recent times, in many countries in the world, there has been a significant growth in employee share ownership. • Though there are several forms of employee ownership, ESOPs, have achieved the most widespread acceptance and support. • The reasons advanced for the adoption of the ESOP concept in the United States are relevant to circumstances currently prevailing in South Africa. In fact there are added reasons why, in South Africa, the encouragement of employee share ownership has an even greater significance: • firstly there is concern, which has been voiced by numerous public authorities and others, about the high degree of concentration in the South African economy and about the importance of taking steps to encourage de-concentration; • secondly, and closely linked to the foregoing factor, there is a desire to democratise, to a greater extent, the ownership of assets, which entails the spreading of ownership among a greater number of individual shareholders in the private sector; and • thirdly, there is the desire to promote employee economic empowerment.

3. Why support ESOPs • Companies are likely to support ESOP initiatives if ESOPs are good for business. For any responsible corporate citizen, something will be good for business if it’s good for the entity itself, good for employees and good for shareholders.

4. 1. Why good for the business • Improve business performance • Do companies with ESOPs perform better than those without? On balance, existing academic studies associate ESOPs with higher productivity levels (matrix evidence, 2010)

5. 1.1 Improve business performance (cont...) • The studies found that share ownership, in particular, has the most discernible impact on productivity and its impact increases when combined with other forms of pay. • The employee ownership index compiled by Field Fisher Waterhouse LLP (2012) showed that listed companies that are at least 10% employee owned outperformed the FTSE All Share Index by an average of 10% since 1992 • The studies however indicate that productivity benefits depend on other factors like the size of the company and are generally higher for smaller companies. ESOPs should be combined with employee engagement for productivity to occur.

6. 1.2 Increase economic resilience • Research conducted by Lampel, et al (2010) found that companies with ESOPs display less variability over the economic cycle, and in particular, were more resilient during economic downturn.

7. 1.2 Increase economic resilience • The explanation is that while non employee owned companies tend to swing between excessive risk taking and excessive risk aversion, employee owned companies tend to maintain a consistent approach towards risk. Employee owned companies tend to take a long term view. • Employee owned companies also show greater preference to internal growth vs external growth. This preference may be explained by the extra difficulty employee owned businesses face in raising capital

8. 1.3 Greater employee commitment and engagement • ESOPs provide a catalyst for greater employee commitment and engagement • Employee engagement refers to a workplace where employees are committed to their organisation’s goals and values, are motivated to contribute to the company’s success while at the same time enhancing their own sense of well-being. • Drivers for effective engagement include” • Strong leadership • Engaging managers • Employees feeling they are part of the organisation • Belief amongst employees that the organisation lives its values

9. 1.4 Driving innovation • Recent studies suggest that ESOPS can drive innovation • Research by Lampel (2010) found that employee owned companies tend to have long term focus and attach higher importance to “innovative ideas from staff” • Michie and Sheehan (1999) also found that employee involvement is positively correlated with the likelihood of firms innovating

10. 1.5 Enhance employee well being • Research by the Napier University Business School (2011) found that the majority of workers were more satisfied compared to when they worked for companies with no ESOPs. • Ownership is associated with enhanced engagement with management and this positively linked to well being (your voice is heard)

11. 1.6 Reduce absenteeism • In the UK the studies conducted in the manufacturing sector found that profit sharing scheme reduce absenteeism by about 8% while ESOPs reduce it to about 13%. • Data from French companies show that ESOPs reduce absenteeism reduces by about 14% where ESOPS are in place vs 7% for profit sharing schemes

12. 1.7 Enhances compliance with BBBEE • Compliance with BBBEE codes of good practice. In South Africa companies can design ESOPs to be one of the tools to be used to achieve compliance with the Codes

13. 1.8 Tax efficient • ESOPs provide attractive tax benefits for companies and make it possible to provide an employee benefit system simply by contributing tax-deductible shares off their own stock. • In SA today, employees on minimum pay have the same tax obligations as executives on the issue of tax. This year’s budget review noted that while ESOPs are supported by Treasury in general, these schemes are often mixed with executive schemes that tend to undermine tax. • Govt is set to review the whole issue of ESOPs in order to address “audit controversy and legislative uncertainty”. • A review is expected to be completed in 2 years time.

14. 2. Who should consider starting ESOPs • One question frequently asked by company leaders on the topic of employee ownership is Are we too small to have an employee stock ownership plan? • Consider what you want to achieve: BBBEE compliance, Staff empowerment, broader remuneration plan, Costs. • Preparing plan documents; • obtaining a valuation; • In a leveraged ESOP, loan commitment fees, • legal fees for the lender's counsel and loan documents, • possibly, financial consulting for structuring the transaction. • administration. • Are your objectives measurable?

15. 3. What’s the best time to start an ESOP • The best way to determine this is to speak with an accountant/financial advisor who has a solid understanding of your company and the options available to you.  In general, if your company meets the following conditions, ESOPs could be your ideal exit strategy: • strong cash flow; • good history with lending sources; • a solid client base; • competent second tier management; • a broad base of employees to be included in the scheme; and • Desire to meet the BBBEE codes.

16. 4. Valuation issues In determining the value of the scheme one needs to consider: • The number of options that are expected to ultimately vest; • The vesting period; and • The fair value of the granted options. • Black-Scholes vs binomial models. • While Black-Scholes is more widely used, it is less flexible than the binomial method and caters specifically for European type options. Since most South African ESOPs can be exercised on any date between vesting date and maturity date (with volatile share prices and interest rate term structure as underlying factors), the use of Black-Scholes is theoretically inappropriate. While IFRS 2(AC 139) acknowledges that Black-Scholes might be appropriate for European options, it can only be used for ESOPs provided it does not give a significantly different answer from a more representative model.

17. 5. Conclusion • In the US, which has a long history of Esops, these have resulted in 25 million employees owning stock in their companies through employee ownership or stock options. In total, this equates to employees being able to exercise share options worth about $800 billion, or about 8% of all USA stock. Listed companies in SA generally do not offer more than 2% of their value to ESOPs. • It is important that we design Schemes that help companies meet their objectives in South African and not only copy the European and American models without taking into account local conditions. We need to do more research on schemes that have been implemented in BRICKS countries as those schemes are more closer to home than schemes designed and implemented in more developed countries.

18. THANK YOU