An employee share scheme involving growth shares enables employees to acquire shares with a low starting value, their eventual value being linked to the company’s future growth.
How they work
Growth shares are a special class of shares which mirror the economic effect of an option grant by only providing participants with the benefit of a share of any growth in the company’s value from the time the shares are issued. The historic value of the company is ignored and the shareholder is only able to participate in the company’s growth between the date the shares are created and an eventual sale or flotation of the company. These shares are often called “growth” shares (because the shares only participate in the “growth” in value of the company).
Growth shares could be an alternative to options, for example for a company which is not eligible to grant EMI options, or they could be used as part of an EMI option plan.
A company has a current value of £5 million. A new senior management team is brought in to run the company and is granted growth shares that entitle them to share in 20% of any sale proceeds in excess of £5 million. Two years later, the company is sold for £7.5 million in cash.
With growth shares, the senior management team will receive (and share) £500,000 as the proceeds of selling their shares. If they had received the proceeds as compensation as part of a long term bonus plan, the £500,000 would be taxed as remuneration. However, as they are receiving the proceeds as holders of growth shares, they are taxed on the basis of capital gains.
For companies considering implementing growth shares, once the class of shares is created they may be issued to participants either through a sale of the shares themselves or by way of a grant of EMI options over the shares in the class (or a combination of the two). The tax and accounting implications of each method should be considered, both for the company issuing the growth shares as well as for the participants acquiring the shares or options over the shares.
Purchase of growth shares
Purchasers of growth shares may be able to acquire the shares outright for a very low purchase price, as the value of the growth shares at the date they are issued is small (because the shares do not participate in the historic value of the company).
Options may be granted over growth shares in place of a straightforward subscription and in some circumstances this may be an attractive alternative approach. Where the company is eligible to grant EMI options, this can make it much more likely that the capital gains tax rate on selling growth shares will be 10% under entrepreneurs’ relief.
We would recommend that advice is sought on valuation before growth shares are issued.
What happens if a participant leaves?
If you want to use your growth share plan to encourage participants to stay with your company, you could:
- stipulate that growth shares must be sold for nominal value if an employee leaves; or
- stipulate that they must be sold on leaving but the price will depend on the reason for leaving (good and bad leaver)
There are a number of potential issues that should be considered prior to implementing growth shares.
Unlike EMI and CSOP, a growth share scheme does not carry specific statutory tax advantages. Although the objective of growth shares is to secure capital gains tax treatment, this treatment cannot therefore be guaranteed.
This is relevant to companies which have investors claiming EIS relief. One of the fundamental conditions for investments from individuals pursuant to an Enterprise Investment Scheme (or EIS) is that the class of shares acquired by an EIS investor is the lowest class (typically, ordinary shares). With their limited capital rights, growth shares may rank below ordinary shares and their creation may result in a disqualifying event for EIS purposes. It is still possible to implement growth shares for a company that has received an EIS investment, but such shares should not have inferior rights compared with ordinary shares.
One Off Transaction.
As the threshold over which growth share holders will share in value will be based on the company’s value at the time holders first acquire them, the implementation of a growth share scheme should be considered to be a “one off” transaction. This is because if the company grows in value subsequently, any further issue of growth shares may cause immediate income tax issues because they will then have a value. Further, any new grant of options over growth shares may have an impact on the company’s profit and loss account. Therefore, if the value of the company has increased since the creation of growth shares, the company should either increase the price of the growth shares (relative to the growth in value of the company) or create a new class of growth shares (with a revised value threshold).
|Tax efficiency (individual)||Tax efficiency (Company)||Ease of setting up||Overall incentive reward value||Other issues|
|No IT or NICs if shares purchased for market value. CGT on sale of shares.||No CT deduction if shares purchased for market value. No NICs on same condition.||Requires change of Articles to create new class of share.||Simple to explain, little risk, tax efficient – but its value as a reward will depend on how high the hurdle is set.||Valuation questions will arise on receipt of growth shares.|