Trying to incentivise employees as a start-up — whether you’re an early-stage company or one that’s beginning to scale up — can be a tough balancing act. Often cash is tight, so asking investors to pay top market rates for talent who can make a difference is challenging.
Increasingly, companies are opting to use a different tactic altogether — employee share schemes.
Luckily, we have several schemes in the UK that are a good fit for this scenario, the most tax efficient of these being the EMI scheme. However, there are cases where either a person is not a ‘qualifying individual’ for EMI purposes, or the goal of incentivising them is not met by granting an ordinary share right.
What are growth shares and how do they work?
Growth shares have become an extremely popular alternative, or complementary route, to the ordinary EMI option. They participate in the proceeds of the sale of a company once a value hurdle has been reached. For example, the hurdle could be set at £5m — any proceeds below this would go exclusively to other shareholders, and the growth share class would participate in value above the £5m hurdle. Effectively, this allows the company to ‘protect’ the value that has been created.
Alternatively, the hurdle could be higher than the existing company value — to drive higher growth. However, the methodology required to value the shares is significantly more complex than for an ordinary share.
Valuing growth shares
When valuing growth shares, we are bound by case law, which means that we need to look forward rather than at historical value indicators. This adds complexity to the valuation, as we must consider the current value of the future earnings potential of the company in question. It involves thinking about future performance, analysing whether the valuation methodology is appropriate, and looking at various scenarios to weigh up the likelihood of success.
There’s a common misconception that if you use a hurdle, the growth shares will become worthless. But there’s almost always some inherent value in these shares, which means issuing them for nominal value can result in a tax charge for the recipient. I’ll discuss the tax consequences in the next blog of this series.
It’s also possible for EMI options to be granted over growth shares. This allows two things to occur. First, the recipient receives the tax benefits of the EMI scheme without facing tax consequences at the time of grant. Second, it allows us to agree a value with HMRC, which provides clarity on any future tax implications.
Weighing up the benefits of growth shares
It must be said, the use of growth shares is a very complex exercise. This is made even more so when a company has received Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) funding. Juggling these schemes can be tricky: between tax advisers and lawyers, you need to ensure you meet the requirements of both S/EIS and the commercial objectives of the growth share scheme.
While creating a growth share class can be challenging, it’s an extremely flexible tool to attract new staff. In addition, it can also protect the value that’s been created by members of the team who are already option holders or shareholders. In the long run, growth shares may be vital to growing and developing your business and attracting key employees who make a difference.
If you’d like to further discuss the potential uses of growth share schemes or how to put one in place, please contact me (Jak.Henderson@ct.me), or the wider Entrepreneurial Tax team (Entrepreneurialtax@ct.me).
Author: Jak Henderson, CT: Entrepreneurial Tax
