Employee share incentive design
- Helen Curtis
- Updated: Thu, 16th Feb 2017
To implement the best share incentive plan you need to be aware of the possibilities. We explain the possibilities and what is best for your business. An employee share scheme designed correctly can reduce your total tax cost, plus attract and retain talented employees.
Our share incentive plan design service includes:
Our experience ranges from smaller UK SMEs to employee share incentives for international trading operations.
Share incentive plan design choices
In the UK the possibilities are virtually limitless. The number of companies implementing employee incentive plans is increasing in the UK. Employers can chose between:
- Shares: Here the choice is between a gift of shares or growth shares.
- Options: Here the choice is between HMRC approved options, unapproved options and phantom options.
- LTIPs: LTIPs can involve the use of shares or unapproved options. LTIPs can also be used to hold shares for employees subject to satisfaction of conditions for release of the shares to employees free of any conditions.
- Phantom: Here share performance is used as the measure for a cash bonus. Shares are not physically issued.
Most popular employee incentive plan choice
Of the available choices, the most popular employee incentive plan is an option. Options carry a proven track record of increasing profitability. If the employer and the employee can fit within the legislative requirements EMI options are the currency of choice.
Share incentive plan design – Asking the correct questions
We will challenge the employer and help them think along the correct lines from the start.
1. Employer’s use of discretion on who and terms of participation
Employers need to decide do they want to benefit the entire workforce or a select few. The decision will help define the choices.
- The SAYE and SIP share plans are not discretionary. All employees must be invited to participate. There is not the ability to pick and chose participants as is offered under the CSOP option regime.
- EMI options are discretionary but larger businesses and groups will not qualify.
- CSOP options are discretionary but the size of the award is limited.
- The gift of shares is discretionary but there are issues which frequently arise over matters such as authority to gift, dilution, what to do with good and bad leavers and fluctuating share values.
- Unapproved options are discretionary but not tax efficient.
2. What % of equity does the employer want to provide to employees?
Typically existing shareholders agree a pool, and grant directors the discretion to use the pool. If employees leave and lose entitlement, the shares surrendered by former employees can, if that is desired, return to the pool to provide for new awards.
3. What performance conditions, if any, will be attached to prior to exercise of the options?
Here the follow-up question is what outcomes can the employees influence?
4. When will the options become exercisable?
Decide what happens on:
- Reaching milestones: for example, years of service, financial targets; etc;
- Sale of the business;
- De-merger of a business stream;
- Voluntary arrangement/administration order.
5. What happens if an employee ceases to be employed?
Should special provision be made for death, injury, disability or redundancy – usually these decisions are left to the directors.
6. How much will the employees pay to acquire shares?
Decide if the equity be given away free. Alternatively, employees could pay something on acquisition. There are no fixed rules.
Linked into this consideration is should employee enjoy inherent value accumulated pre-award? The tax position for the employees is driven by the deemed benefit they receive when they receive shares which is integral to the question of how much the employees pay.
7. How will the shares be sourced?
There is a choice of newly issued which dilutes existing shareholders or using shares held by existing shareholders. For new share issues it is necessary to consider whether the directors have the requisite shareholder approvals to issue shares pursuant to the option/share awards. If existing shares are being used it is usually necessary to consider the tax position of the transferors. Some companies link equity awards to share buy backs under which existing shares are cancelled.
8. Are the existing articles and/or shareholders agreement adequate?
- For example what will happen if an employee leaves? Do you need good/bad leaver provisions? This is an area where employers often make mistakes which mean ex-employees walk away holding shares.
- The employment contract is quite separate from any contract for equity. This means you can fire as an employee, but unless the corporate constitutional documents expressly cover the point, the employee or director will remain a shareholder.
- If you are going to force a transfer of shares on cessation of employment – how will the shares be valued? There are plenty of choices ranging from a valuation by the accountants to the ability to appoint an independent expert.
- What valuation method will be used? Again, choices are available.
9. What are the tax implications on award of shares
The provision of shares will give rise to tax charges. The amount and timing of the charge depends upon the type of award made. There are design features that some employers consider to reduce the taxable value of the shares. Growth shares are one such example.
For private companies
You need to consider the taxable value of the shares so that the liability is not unexpected. It is the employees who have the income tax liability. However, in some cases, the employer has a tax withholding liability under PAYE. We advise directors of private companies on likely taxable values of shares awarded.
There are a range of factors to consider such as:
- Whether the value of the shares can be reduced for tax purposes to take account of minority discounts, and if so, what percentage of discount is HMRC likely to agree?
- Are there restrictions on the transferability or capital value of shares which will reduce their taxable value.
- What are the particular risk factors for the business. For example, HMRC will accept that some sectors such as high tech businesses developing intellectual property are risky than more established businesses.
- If there has been an investment round recently at what price did investors acquire shares.
For quoted companies and private companies where there is a ready market for the shares
There will be an obligation to operate PAYE. The taxable value of the shares will usually be based on the traded price.
Sale of shares
A different set of considerations apply on sale of shares by employees as discussed below.
10. How will the employees dispose of their shares?
Perhaps the most important question for employees is – when will I receive value? The shares are worthless to an employee until disposal.
For private companies
There is no ready market with private companies into which the shares can be sold. That means for the employee to receive value a market has to be created. Typical ways out for employees include:
- Sale of shares acquired upon exercise of option on “exit” – meaning the sale of the business. Options are popular because shares are not issued until immediately before the exit. The advantage here is that the administration of dealing with employee shareholders is avoided.
- Sale of shares to an employee benefit trust. The employee benefit trust acts as the market for the employees as if funded by the employer the trustees can buy shares from employees.
- Company share buy backs – a good way to utilise distributable reserves.
11. How much tax will the employees pay on sale of their shares?
Employees, like any other tax payer, will be subject to capital gains tax on disposal. However, there are two selling points. Firstly, the rate of capital gains tax much lower than the rate of income tax and national insurance. Secondly, there is an annual capital gains tax exemption that is available to reduce the amount of any capital gains tax payable.
For private companies
We work with many employers to design share awards that will qualify for entrepreneurs’ relief as this brings the rate of capital gains tax down to 10%.
Share incentive plan – Risk with poor design
A badly designed share incentive plan gives away more equity than intended and does not enhance shareholder value. You risk demotivating employees and driving them into the arms of competitors, if you fail to meet their expectations.
Disaster areas in poor design of employee incentive plans
We guide you away from known disaster areas.
- We prepare share capital dilution tables plotting the fully diluted position if all options and share rights are taken up.
- We review the articles and shareholders’ agreement to make sure you obtain the requisite shareholder approvals.
- We deal with the filings required at Companies House on the issue of shares to employees. Filings are also required if you introduce new classes of shares or vary the rights attaching to shares which is a point employers can miss.
- We use previous experience gained in implementing employee incentive plans to avoid problem features.
- We will prepare suitable employee communications designed to avoid complaints from participants under the employee incentive plan.
- We think about the bigger picture such as what should happen if the business is sold.
- We consider the tax liabilities arising on share awards. We develop ideas designed to minimise the tax charge arising for employees and directors on award.
If you do find there are claims from employees we can defend those robustly for you.
Employee incentive plan design track record
Our focus is on privately owned companies which are UK controlled or controlled by an overseas parent. Our work with unquoted companies is varied as unquoted companies are not subjected to the same restraints as publicly quoted companies.
Recent instructions include:
- Bespoke Long Term Incentive Plan to compliment existing share option plan, for a national recruitment company.
- Unapproved option: that only vests upon a change of control. Our client aimed to sell his private limited restaurant chain within five years.
- Option, with different class rights, for a financial technology company. Senior employees and traders could vote, using the shares that they were to acquire.
- Drafting a phantom option agreement for a trading company owned by an off shore trust where they only wanted to provide a benefit if the UK subsidiary performed.