Guide to growth share schemes

Incentivising, motivating, and retaining the most talented members of your team has never been more important, but issuing shares to employees can be riddled with potential tax issues.

In this guide to growth share schemes, we'll be looking at how growth shares can be issued to individuals to allow them to participate in the future growth in value of a business…

Many companies want to use equity to reward and incentivise key members of the workforce. Unfortunately, if a suitable scheme is not used, simply issuing or transferring shares to staff, directors and consultants can result in unforeseen tax consequences. Unless the relevant individuals are prepared to pay market value for their shares, this can result in income tax and, in certain circumstances, NI charges arising on acquisition and/or income tax (rather than capital gains tax) and national insurance being charged on some or all of the uplift in value made when the shares are sold.

For this reason, tax-efficient employee share schemes such as EMI share schemes are a popular way to allocate a share of the equity to employees.

However, there are various scenarios in which EMI share schemes are either unavailable or undesirable, such as where:

  • The company issuing the shares is a subsidiary company.
  • The company is too large (currently >250 employees or with gross assets of >£30m).
  • Shares are to be issued to employees on day 1, rather than share options being granted.
  • An individual is not an employee of a company, or spends less than 25 hours per week / 75% of their total working time as an employee of the company.

Growth shares are a separate class of share capital which only carries rights to share in the future, increased value of the business. We are seeing rising numbers of clients choosing growth share schemes for their versatility and flexibility, particularly (but not exclusively) where tax-advantaged employee share schemes are not available. It is, in fact, possible to issue options over growth shares inside of an EMI scheme if the company and the potential recipients of the options qualify.

How do growth share schemes work?

The principle behind growth shares is very simple: the current value of a business is calculated, and a new class of shares is created which only carries any capital rights if that value increases. Growth share schemes are very flexible, and the rights attaching to the share class (and when they are triggered) can be tailored accordingly.

Unlike share option schemes, growth share schemes allow shares to be issued to participating shareholders on day 1. Growth shares usually only have low value because, if they were sold at that point, the shares would not entitle the holder to receive any proceeds. The shareholders will generally then need to wait for the value of the business to increase before they receive any value for their shares. Until recently, HMRC would accept a nominal value for growth shares where the hurdle over which the growth shareholders received any value was set at more than the market value at the time of issue of the shares. However, HMRC has changed its approach to agreeing growth share valuations and will take into account projections in order to place a "hope value" on the shares.

Growth share schemes are also a neat way to ring-fence the current value of the business for existing shareholders, whilst incentivising key players to grow the business and share in any upside in its value. This approach can also avoid existing shareholders being diluted (at least in respect of the current value of the business) by the issue of equity to team members.

Growth share scheme: worked example of exit proceeds

Knickerbocker Limited currently has a share capital of 1,000 ordinary shares of £1 each and is valued at £4m.

The company decides to issue 100 growth shares of £1 each to management, for which management pay a cash subscription price of £10 per share. The growth shares only entitle management to share in the proceeds where there is an exit for at least £5m. 

Knickerbocker Limited is subsequently sold to a third party for £10m and the proceeds are distributed as follows:

  Ordinary shareholders Growth shareholders
First £5m £5m N/A
Second £5m £4.545m £0.455m
Total £9.545m £0.455m
% share of proceeds on a £10m exit 95.5% 4.5%
% share of proceeds on a £20m exit 93.2% 6.8%
% share of proceeds on a £50m exit 91.8% 8.2%

 

As you can see, the first £5m of proceeds will always be ring-fenced for the holders of ordinary shares, but the higher the exit value, the higher the percentage that the holders of growth shares receive. In the above example, an exit at £50m would mean holders of growth shares receiving c.8.2% of the total sale proceeds.

What is the process for setting up a growth share scheme?

  1. The business needs to be accurately valued so that the mechanics of the growth share scheme can be considered. Business valuations are always subjective, but this exercise should be undertaken carefully by expert advisers using an appropriate methodology to minimise the risk of tax issues arising further down the road due to the current HMRC approach to growth share valuations.
  2. The company's articles of association need to be amended/updated to create the new class of growth shares that are to be issued. As discussed below, there are various related considerations that will need to be looked at, such as what happens if a holder of growth shares ceases to be involved with the business.
  3. The approval of shareholders will be required to approve the adoption of the new articles of association and the issue of growth shares to the relevant individuals.
  4. Individuals are then invited to subscribe for growth shares, typically by signing up to a subscription agreement (and, if appropriate, any existing shareholders agreement). The subscription agreement will usually contain details of the value threshold being used for the growth shares, along with any provisions relating to vesting and any other conditions/KPIs attaching to the growth shares.
  5. The individual will need to pay cash for their growth shares or, if they are not required to pay for them, income tax will need to be calculated and paid (albeit, as discussed below, this will typically be a small amount).

Can growth shares have different thresholds/conditions for different shareholders?

Yes. This will often be appropriate to reflect practical considerations such as the seniority of different individuals within the business and to reflect changes in the value of the business at the point when they receive their shares.

For example, the issue of growth shares when a company is worth £10m will inevitably need a higher threshold than was used for an issue of growth shares when the company was only worth £5m.

Does the recipient have to pay for the growth shares?

Yes. Growth shares will typically have a low value to reflect the fact that they carry future hope value in the growth of the business, but there will still be something to pay (even if it is the nominal or 'face value' of the growth shares).

These can be paid for in cash by the employee, or if they do not pay for the growth shares, they will need to pay income tax on the initial market value of the shares at the time the shares are issued.

What happens if a holder of growth shares leaves the business?

When implementing a growth share scheme 'leaver' provisions will typically be included in the articles of association which will govern what happens when a holder of growth shares leaves the business.

This will generally include a distinction between a 'good leaver' (where, for example, the individual is forced to retire because of ill health) and a 'bad leaver' (whose reason for leaving the business is deemed less meritorious). Discretion can be given to the board to designate an individual a 'good leaver' on a case-by-case basis. As a general rule, good leavers will have the ability to retain some or all of their growth shares or receive value for them, whereas bad leavers generally will not. Again, this is something that can be tailored by the issuing company.

Growth share schemes can also include vesting timetables so that the rights attaching to the growth shares effectively accrue over an agreed time period.

How are growth shares taxed?

Provided the growth share scheme has been set up correctly, and the shares are paid for, the recipients of growth shares do not pay any income tax when the shares are issued to them. If the shares have not been paid for, then income tax will need to be calculated with reference to the market value of each individual's growth shares at the time they are issued.

The final tax treatment on disposal of the growth shares will depend on whether or not the growth shareholder has made a tax election under section 431 Income Tax (Earnings & Pensions) Act 2003. This article will not go into the detail of this election, but it is unusual for the election not to be made and, therefore, we will assume that this has been made.

If the scheme has been implemented correctly and the section 431 election above has been made, capital gains tax will be payable on any gains made on disposal of the shares.

Unlike alternative schemes such as EMI schemes, no valuation is agreed with HMRC at the time that a growth share scheme is implemented. However, expert assistance should always be sought to agree an appropriate valuation internally. There are various potential tax issues for both the company and the individuals involved if HMRC subsequently deems that the valuation used was lightweight (and the growth shares have effectively been issued at an undervalue). 

Where a growth share scheme includes a threshold – i.e. the growth shares accrue value above a stipulated higher valuation, rather than simply any growth above the current valuation, this helps to mitigate this risk. The threshold will typically be in the region of 10% - 20% higher than the market value of the business at the time the shares are issued (but can be set at a higher level if the plan is to incentivise your team to deliver very significant growth). If HMRC were to deem the threshold too low, assuming that the election above has been made, the risk would be that income tax could be charged on the difference between the unrestricted market value of the shares on issue and the price paid. 

The company would need to inform HMRC of the issuance of the growth shares in the annual return on or before 6 July following the end of the tax year in which the shares were issued.

Growth shares in an EMI wrapper

Most of the above also applies to options issued under an EMI scheme for growth shares. The advantage of issuing options under an EMI scheme rather than shares being issued is that the valuation can be agreed with HMRC in advance. If the options are only exercisable on an exit, this reduces the need for leaver provisions in the company's articles of association as the growth shares will only be in issue for a very short amount of time immediately prior to the exit.

Can growth shares be used in EIS-qualifying companies?

Growth shares cannot be issued by companies that either already have EIS investment that is still within 3 years of investment, or are going to raise funds via EIS. The reasoning for this is that the existence of the growth shares means that the "normal" ordinary shares have a preferred right which precludes EIS relief.

Growth shares and Business Asset Disposal Relief (formerly known as Entrepreneur's Relief

Business Asset Disposal Relief (formerly known as Entrepreneur's Relief reduces the rate of capital gains tax on the first £1m of lifetime gains in qualifying assets to 10%.

In order to qualify for Business Asset Disposal Relief, a number of conditions have to be met. Due to these conditions, it is unlikely that growth shares will qualify. However, in the case of growth shares issued within an EMI scheme, most of those conditions are waived and it is possible that Business Asset Disposal Relief will be available on growth shares issued via this method.

Are growth shares suitable for family businesses?

Whilst growth share schemes are most commonly used to incentivise staff, they can also be a very useful way to manage succession planning in family businesses.

For example, where one generation of the family is looking to retire and hand the business over to the next, a growth share scheme would ensure that the value created by the older generation is ring-fenced, whilst the younger generation is rewarded for their future efforts to grow the value of the business. This approach can be used as a tax-efficient measure in the context of a wider succession planning exercise.

Can growth shares be issued to corporate shareholders?

Yes. Please note, however, that this guide assumes that the growth shares will be issued to individuals rather than corporates.

What is a ratcheted growth share?

Ratchets are used to vary the entitlements of shareholders to participate in capital proceeds at different thresholds. For example, a class of shares might entitle its holders to 2x proceeds above a certain threshold.

Growth share schemes can also incorporate ratchets. For example, the hurdle might be set at £10m, and a ratchet might then sit on top of this so that the relevant shareholders will receive 2x proceeds above £15m.

Some care will be needed to ensure that the ratchet is structured correctly – if bespoke thresholds/conditions are agreed with different employees it is possible that multiple classes of growth shares may be required.

What are flowering shares, hurdle shares and waterfall shares?

There are multiple ways to structure share classes so that shareholders only participate in certain scenarios. Broadly speaking, each of these approaches is either similar to, or compatible with, a growth share scheme. Each involves creating a separate class of shares with little or no current value, but with the opportunity to participate in future increases in value. 

Flowering shares tend to 'flower' (i.e. accrue rights) on the occurrence of certain events, which could be the achievement of certain targets such as turnover, profitability or an exit above a specified value.

Hurdle shares only accrue value above certain thresholds. Growth share schemes often integrate a 'hurdle' feature.

Waterfall shares are used to determine the order in which different classes of shares participate in a capital event. This will typically involve certain shareholders receiving proceeds first, with other shareholders receiving their distributions subsequently.

Do growth shares allow the shareholders to vote and receive dividends?

The choice is yours – most companies prefer not to give voting or dividend rights to holders of growth shares to ensure that control over the company is retained by the existing shareholders, and the value is released to employee shareholders on an 'exit only' basis akin to share options.

However, there is a growing movement towards accountability and employee ownership, and growth shares can be given voting and dividend rights if this is desirable. Again, care should be taken to ensure that this does not prejudice the efficacy of the scheme in terms of establishing the initial market value of the growth shares (i.e. if they carry dividend and voting rights from day 1 they are likely to be more valuable than if they do not).

What role do lawyers play in creating growth share schemes?

We assist with various aspects of setting up growth share schemes, including:

  • Preparing new/updated articles of association incorporating the key terms of the growth share scheme.
  • Preparing subscription agreements (we typically prepare a pro forma subscription agreement that can be tailored by the company for individual employees).
  • Drafting shareholder resolutions and board minutes to ensure that the scheme is validly adopted.
  • Providing a guide to the growth share scheme that can be given to participants to help them understand the parameters of the scheme.

If you would like to discuss any of the issues raised in this article, or would like to learn more about Share Schemes, please contact Dan Partridge in Michelmores' Corporate team.

This article is for information purposes only and is not a substitute for legal advice, and should not be relied upon as such. Please contact our specialist lawyers to discuss any issues you are facing.