Why and how growth share schemes are used
If you are stuck for an alternative to an Enterprise Management Incentive (“EMI”) share option because your company is not a qualifying one, or because the person you want to incentivise does not work enough hours, then you may need to look no further than growth shares. Growth shares also work particularly well as a class of shares over which EMI share options can be granted.
Growth shares are a separate class of shares that a company can create to give the holders of such shares an interest only in the benefit of the growth in value of the company from the time the growth shares are issued. For example, if the company is worth £2 million at the time the growth shares are issued, the growth shares would only participate in the growth in value of the company above £2 million. In other words, the addition of a new shareholder on growth share terms means that the existing shareholders of the company are not diluted as to their ownership of the current value of the company.
There are several good reasons for using growth shares:
- one is the commercial rationale that as an incentive award it only allows the holder to share in the growth in value that they are actively contributing to.
- another one is driven by tax considerations. In principle, as long as the recipient of the growth share pays the nominal (or par) value of the share (whether that is £1.00, or £0.01 for example) and as long as the value of the company has been accurately estimated and ring fenced in the share class rights, the holder of the growth share will not be receiving anything of current value and therefore no income tax charge should attach to it.
- a different one is that growth shares do not have to meet any statutory requirements or limits and that the terms attaching to the growth shares can be tailored to suit the commercial needs of the company.
- one more is that participation can be selective. This means that the board of the company does not have to offer growth shares to every recipient on equal terms. The ability for the board to set particular hurdles to different holders of growth shares avoids the need to amend the articles each time new classes of growth shares are issued, ensuring in this way that the arrangements remain private and flexible.
Making a growth shares arrangement involves considerable effort and expense on the part of the company, including the services of both:
- a share valuation expert to value the company and the growth shares; and
- a professional legal adviser to draft the growth shares plan and the necessary changes to the company’s articles of association.
Valuing the growth shares is critical to the success of the arrangement. If the value of the company is underestimated, and the shares are issued to an officer or employee, then that value will trigger an income tax charge for the individual.
If you overestimate the value of the company, then instead of creating a growth share you will create a hurdle share. A hurdle share is a type of share that allows the holder to benefit only from growth in the value of the company above a hurdle which exceeds the current value of the company. So, taking the earlier example, if a company is worth £2 million, a class of share that only participates in growth above £2.5 million.
On a side note, if you create a class of share that only allows holders to participate in the value of the company if when a specified performance condition is met (for example, exceeding a minimum exit price), then this would be what is known as a flowering share. Flowering shares require an even greater degree of caution in their design because they are very vulnerable to challenge by HMRC as being convertible securities and therefore often subject to an income tax charge.
Unlike EMI, valuing growth shares cannot be pre-approved with HMRC. However, an independent professional valuation (by your accountant) will usually provide an adequate valuation of the growth shares by taking in the account the following factors:
- The current value of the company
- The valuation procedure
- The intrinsic value of a growth share
- The expectation value of a growth share
- Any applicable discounts
- Unrestricted market value
The participants in a growth shares scheme become holders of the shares from ’day 1’, meaning that additional elements (such as drag and tag provisions) should be included within the company’s existing articles of association, to ensure that dilution and exits are handled correctly and the company and other shareholders are properly protected.
Similarly, the participants in a growth share scheme will be required to sign a subscription agreement setting out the rights and restrictions applicable to that particular participant. For example, the company may reserve it’s right to buy-back the growth shares if the participant does not meet certain performance targets or ceases to be an employee or director of the company.
In addition, the holders of growth shares will need to be entered into the company’s registers of members and will be on the public record. However, if the intention is to keep the growth shares awards confidential, a nominee could be appointed to hold the growth shares on the participant’s behalf.
An important issue to consider early on when planning to introduce growth shares is to assess the company’s potential for growth. If a reasonable level of growth is not likely over the period by the end of which the company wants the growth shareholder to benefit, then a growth share arrangement may be more disheartening than incentivising for the individual.
The rights attached to growth shares (i.e. rights to voting, dividends and capital) are at the discretion of the board of the company and its shareholders.
Therefore, although the default position is that growth shares have no rights to dividends at all, it might be appropriate to offer dividends to the holders of growth shares when, for example, a company regularly pays dividends to its existing shareholders.
It can be done so by reference to the relationship between the current value of the ordinary shares and the target value, so that:
- while an ordinary share is worth less than, or the same as, the target, dividends are not payable on growth shares;
- while an ordinary share is worth more than the target, dividends are payable on growth shares at the same proportion to the corresponding dividend payable on an ordinary share
It is worth mentioning that a growth share with dividend rates may have a value that exceeds its nominal value because the hope value attaching to receiving dividends could have some value increasing factors. So, expanding on the earlier example, if the company has a history of regularly paying dividends (such that the expectation of the growth shareholders receiving a dividend is greater) this could increase the value of the share even absent capital rights on the issue of the shares.
Paying dividends on growth shares may be disadvantageous for those companies that do not commit to regular valuations of the company’s shares, as they would be required to undertake at least an annual valuation of the shares.
Caution needs to be applied if you are looking for investment via the Seed Enterprise Scheme (SEIS) or Enterprise Investment Scheme (EIS).
Growth shares can negate SEIS and EIS qualification status by causing other shares to inadvertently obtain preferential rights. For example, in one case (Abingdon Health Ltd v HMRC), a company introduced growth shares and made amendments to the articles of association that gave the holders of ordinary shares priority on a return of assets of a liquidation. This resulted in EIS relief being withdrawn.
You can find more information on how to apply for SEIS and EIS advance assurance here.
Business Asset Disposal Relief may be available for growth shares if the necessary conditions (particularly 5% of ordinary share capital and voting rights, and either 5% of the sale proceeds or 5% of profits) are achieved, or where the growth shares are acquired through an EMI option.
As result, companies will have to enhance the voting rights and weighted the nominal values of the growth shares in order to benefit of the fixed rate of 10% on capital gains provided through the Business Asset Disposal Relief scheme. You can read more information on how to get Business Asset Disposal Relief on the sale of a business or shares here.
Growth shares can be used for employment reward and will require, in addition to amending the company’s articles, to adopt an employee growth shares plan. This should include rules dealing with matters such as:
- the terms on which growth shares will be acquired (this could be as simple as ‘turn up each day’ or requiring performance conditions to be met before growth shares cease to be subject to a risk of forfeiture);
- indemnities from employees receiving growth shares in respect of PAYE and national insurance contributions (NICs) liabilities and a requirement to make joint NICs elections on the company’s direction;
- clauses that would protect the employer against claims for loss of a share award arising from a wrongful dismissal claim (Micklefield clauses).
Furthermore, a share subscription deed has to be prepared for employees who subscribe for newly issued growth shares. For the employees who acquire existing shares from an employee benefit trust. a purchase agreement should be provided and the company should be a party of such an agreement or at least have the benefit of various provisions of it.
There are two common issues to consider when you think to introduce a growth shares award for employees.
One is regarding the situation where the employee does not meet the expectations set in the subscription deed. The shares can be fully or partially cancelled if the share award is still within its ‘conditional’ period’, but if the shares are ‘unconditional’, the employee will remain the full owner of those shares, regardless of whether leaves or stays in the business. As a result, it’s important to include in the subscription deed a definite period that allows to correctly judge if the person has met the expectations.
The second one refers to what happens if the employment is terminated. To the extent that the company’s articles or the subscription deed provide transferring provisions, the company can transfer the growth shares on the termination of employment, otherwise, the employee will retain his growth shares post-termination.
The lower market value of growth shares means that more shares can be awarded within the EMI individual limit (currently set at £250,000).
As employees receive economic benefits from their growth shares on an exit or at the end of a performance, the flexibility of EMI options means that they can be used for exit-only arrangements, as well as for options exercisable at the realisation of a certain event. When the EMI options become capable of exercise, the employees can acquire their growth shares by paying the option price for them. They will then immediately sell the growth shares to the acquiring company and may benefit in a proportion of the exit proceeds corresponding to the extent that they exceed the growth share hurdle.
It can be particularly tax-efficient for both employer and participating employees to grant EMI options over growth shares, which can result in:
- for the employer:
- not tax cost (subject to certain conditions);
- no employer’s NIC on either the grant or exercise of the options (subject to certain conditions); and
- corporation tax relief on the difference between the market value of the shares when they were acquired and the option price paid subsequently.
- for the employee:
- lower tax costs than cash or non-EMI arrangements;
- no income tax and no employee’s NIC on either the grant or exercise of the options (subject to certain conditions);
- Capital Gains Tax (“CGT”) on the growth in value of the growth shares; and
- the benefit of the Business Asset Disposal Relief. The 2-year Business Asset Disposal Relief qualifying holding period runs from the date of grant of an EMI option, so the EMI option holder does not need to hold the resulting share for a further 2 years in order to qualify for Business Asset Disposal Relief. In addition. EMI option holders do not need to hold 5% of shares by nominal value, voting rights or economic value to potentially qualify for the 10% (as opposed to 20%) rate of CGT.
One particular advantage of granting EMI options over growth shares scheme is that the valuation of growth shares can be pre-approved by HMRC, providing in this way tax and valuation certainty to the company and employees alike.
The only disadvantage of this arrangement is that companies and employees need to met certain qualifying conditions in order to qualify under EMI. Some of these can be restrictive, but HMRC can be approached for pre-clearance. You can find more information on how EMI option schemes work here.
Similar to employees, growth shares may also be awarded to consultants in exchange for their services to the company. The consultants may further qualify for Investors’ Relief provided they met certain conditions (in particular that they receive no more than ‘reasonable’ remuneration for their consultancy services and they hold the shares for at least three years).
In contrast to Business Asset Disposal Relief, there is no requirement regarding a minimum nominal value or voting rights. However, in order for consultants to benefit from 10% tax rate on capital gains, the growth shares awarded to them must be issued for ‘genuine commercial reason’ and not as part of a tax avoidance scheme.
To read more about what is Investors’ Relief and how it works, you can click here.
Setting up and running a growth share plan involves careful and detailed planning. At Jonathan Lea Network we can advise on all aspects of establishing and operating a growth share plan, including designing vesting and leaver provisions that meet the commercial requirements of your company, drafting the changes to the articles of association, preparing the growth shares subscription agreements and associated documentation.
For all new clients, we offer a no-cost and no-obligation call of up to 20 minutes to first discuss your matter and requirements before confirming a scope of work and quote. This can be arranged by sending your details together with an overview of your matter through our contact form.