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Retaining talent and building value with share incentives and smart structures

Retaining talent and building value with share incentives and smart structures

Is retaining your key employees in a competitive marketplace a concern for you?

It is for many of our clients, particularly those who have an exit in mind and who need those individuals to support them in growing their business.

Have you considered a share option scheme or “growth share” structure to retain and motivate your team members? Set up in the right way, you can build a tax-effective structure for both your business and your key employees, creating a real incentive for them to drive your company’s growth so they too can enjoy the rewards on a sale.

In this article, we share examples of how we have helped clients and how this might be of benefit to your business.

EMI schemes

A popular choice for incentivising key employees is the Enterprise Management Incentive (EMI) Scheme. EMI Schemes are approved by HM Revenue and Customs in advance of share options being granted to selected employees. A share option is a right to buy shares at a fixed price in the future. Employees are able to “exercise” their options (i.e. buy their shares) after a certain time (the “vesting period”), at a specified event (e.g. a sale), or after particular performance criteria have been met (e.g. achieving a pre-determined level of profit). The employee doesn’t have to pay anything for the share option when it is granted (although some businesses may want them to do so).

As noted above, HMRC agrees the market value of the share options at the time they are granted to employees, providing some advance assurance. There is no tax charge at this point, provided that the option was granted at (or above) the market value agreed with HMRC. Instead, the employee will pay Capital Gains Tax when the shares are disposed of, assuming that the proceeds exceed the market value at the date of the grant of the option. The shares may qualify for Business Asset Disposal Relief, meaning that the tax rate for the employee on sale could be just 10%.

Example

In a Discovery meeting with the owner of a rapidly growing media business, we learned that he was very concerned about his sales director, “Bob”, leaving to join a rival. He was worried that this might jeopardise his own plan to sell his company in the next five years. It was crucial that he offered Bob a promise of future returns to preserve his loyalty.

We therefore presented our client with alternative share incentive structures, and we concluded that an EMI option scheme was the most suitable for both the company and the sales director.

Bob was granted an EMI option to acquire a 5% shareholding for its market value of £10,000, the valuation for which we agreed in advance with HMRC. Under the term of the options, Bob can exercise if the company’s profit grows to £1 million after five years.

To illustrate how the EMI options work and how they are taxed, we have created the hypothetical scenario below:

The company achieves the target of £1 million profit in five years. Bob can then exercise his options (let’s say that, at this point, his shares are worth £100,000). Two years later, Bob sells his shares for £150,000 when the company is sold to a third party.

Bob will pay no tax when the option is granted, and nor will he pay any tax when the option is exercised.

On the sale of his shares, Bob will pay Capital Gains Tax on the gain of £140,000 (£150,000 sale proceeds less £10,000 option exercise price). Ignoring any personal reliefs which he may have available, tax is charged at a rate of 10% (i.e. £14,000), since the company’s shares qualify for Business Asset Disposal Relief.

As can be seen, EMI options are an extremely attractive option for both the business-owner and the employee, providing significant commercial and tax advantages.

It should also be noted that the company will receive a corporation tax deduction on the exercise of the options. Relief is given in the accounting period in which the EMI option is exercised on the difference between the market value of the share options on the date of exercise and the exercise price. In the example above, £90,000 (£100,000 market value after five years less £10,000 option exercise price) would be set against the company’s chargeable profits, giving rise to a corporation tax saving of £17,100 (£90,000 x 19%).

How Creaseys can help you

We have assisted many clients put together EMI Schemes. Firstly, we will discuss with you what your objectives are and how much equity you are willing to give to your key employees. Next, we draft a term sheet which explains exactly how the EMI options will work and what the key terms will be. We then work closely with your lawyers to ensure that the objectives of the scheme are clearly understood and that the legal paperwork accurately reflects them.

Our Share and Business Valuations Team provides support with the valuation of the share options. It is crucial that EMI Scheme valuations are prepared on a sound and robust basis, so that they are accepted quickly and without challenge when they are sent for approval to HMRC. We know from experience what HMRC expects to see in a valuation report and what the potential pitfalls are, so, to date, we have never had an EMI valuation clearance rejected.

Growth shares

Unlike EMI options, growth shares allow employees to become shareholders straight away. By creating a new class of shares the company can tailor the share rights to provide an effective incentive to the employee to grow the value of the business. For example, a class of shares might stipulate that capital entitlement is only triggered when a particular hurdle is met, such as the company achieving a certain level of profit or valuation (hence “growth” or “hurdle” shares).

Growth shares are a useful alternative for companies which have grown beyond the limits for EMI options (being a maximum share value of £250k per employee), or which are not qualifying for EMI (e.g. professional services and property businesses, or businesses under the control of another company). Some employees may also prefer to have shares now, rather than a promise of shares in the future, even if the outcome is the same in terms of capital rights.

Example

In the course of our “Big Picture” conversation with the owner of a professional services firm, we discovered that he wanted to sell the business in the next seven years. He wanted his senior team to be on board with his decision and to motivate them by reaping the rewards of a successful sale. However, he was unsure how best to go about this.

Firstly, we valued the business as it stood today. Our Share and Business Valuations Team worked closely with the owner and established a current value of £5 million.

We then explored how the senior team could be incentivised to grow the business, whilst minimising the tax payable on the shares issued to them.

After modelling various scenarios, we concluded that the optimal solution was to create a new “growth share” class for the senior team which would give them rights to enjoy 20% of the sales proceeds over £7.5 million.

Our client will have preserved the first £7.5 million of value when he sells his business, and he has achieved the buy-in of his senior team, who have a strong incentive to grow the company to unlock their right to capital in the future.

The tax payable on the issuing of the shares is also negligible because the initial value of the growth share is very low, given that it confers no right to any of the current value of the business, and that the current value of the business and the growth share hurdle of £7.5 million are sufficiently distant.

If the company is subsequently sold for £10 million, the growth shareholders will have a right to 20% of the value in excess of £7.5 million, i.e. £500k. The gain in value would be subject to Capital Gains Tax at the rate of 20%.

How Creaseys can help you

As in the example above, we can help you to establish an appropriate hurdle which is both motivating for your employees and which mitigates the tax impacts. Drawing on our experience of other structures, we can recommend rights which are as simple or as complex as is desired, such as using a ratchet structure to provide rewards for reaching particular targets (e.g. 20% of value above £7.5 million, but 30% above £10 million).

Our Share and Business Valuations Team will also ensure that the initial valuation of the growth share is robust and defensible in the event of challenge by HMRC (who, unlike for EMI options, will not pre-agree valuations for growth shares).

In summary, if you are a business-owner with key people who you need to retain to build value in order to meet your Big Picture objectives – whether an exit is planned or not – you should consider whether share options or growth shares might be beneficial to you. Very often, we find that share incentives align the interests of key employees with those of the existing shareholders, making for a much stronger and focussed business. Furthermore, incentives such as these are a great way to attract new talent, especially where your business is competing with larger firms who can offer higher salaries.

We work with clients on share incentive schemes every day, so if you want to find out more, please get in touch with your usual Creaseys contact or call us on 01892 546546.