Alphabet shares, e.g. A ordinary shares, B ordinary shares, etc., allow private companies to provide different groups of shareholders with different rights. For example, different shareholder rights could be given to each of the founders, investors and employees or directors. The shareholder rights capable of variation include dividend rights, voting rights and capital rights.
Why alphabet shares are popular
Alphabet shares have various forms and labels including restricted shares, growth shares, flowering shares and freezer shares. In all cases the use is the same – to provide different rights to different categories of shareholders. The use of alphabet shares is widespread in the UK. We have designed alphabet shares for a range of companies in different sectors where for different reasons the key shareholders wanted to preserve control.
Alphabet share uses
We have explained below a few of the typical scenarios where alphabet shares add value and flexibility for a business.
Different groups of shareholders working for the business
In many cases the founders are the last to be paid. Employees and directors receive fixed salaries reflective of the commercial rate. Founders take what profit is left after staff and creditors have been paid. Or, founders may retain profits for investment and not take out surpluses. The founders may well want to reward key employees and directors with shares. Being a shareholder can be motivational. There are a wide variety of tax efficient ways to reward employees.
In this type of scenario alphabet shares can work well:
- If the founders or directors hold a different class of shares to the employees the share rights can be varied.
- For example, founders could be issued with A shares which permit a higher (or lower) rate of dividend to be paid compared to the B shares issued to employees.
- The B shares could include compulsory transfer provisions on leaving employment which do not apply to the A shares.
- The permutations between rights to voting, dividend income and capital are limitless.
Alphabet shares held by investors
Investors often require a special class of share is created. Rights can be built into shares held by investors to hedge the risk of investment. This is particularly common in start up businesses.
In this type of scenario alphabet shares can provide benefits to investors such as:
- For example, investors could be issued with C shares providing a preferential claim over capital compared to the A and B shares. On a sale or liquidation of the business the C shares could receive a higher rate of return and in preference to other classes of shares.
- The C shares could confer powers of veto. A list of matters requiring investor approval can be built into the share right.
- A different class of shares can facilitate a mixed loan and equity deal. It is possible to provide rights for loans to be converted into equity and agreed valuations.
Care is required where the investment is under the SEIS or EIS tax relief schemes for investors. The SEIS and EIS legislation does not permit a preference for investors.
Alphabet shares held by family members
Alphabet shares can be used to pass ownership of a business to family members. The alphabet shares used to achieve succession planning are often called “freezer shares”. Freezer shares can be used to lock in existing value. Dividends can be tailored to provide certainty of income to cover items such as nursing homes.
For example, a new class of E shares – freezer shares – could be issued to the next generation. The E shares could provide:
- A right for the company to buy back shares from the senior generation at a pre-agreed value and or pre-agreed dates.
- A right to receive a preferential dividend ahead of other dividend payments. The idea is the older generation will have enough to live on profits permitting.
- In cases where the older generation is concerned about divorces or irresponsible family members breaks can be built into the shares. The break would deny prescribed rights such as dividends and or capital.
- It is possible to pass the shares on death to spouses on terms which remove voting rights. This works where the spouse is not part of the business and avoids the risk of meddling.
Alphabet shares can from part of an exit strategy
Sometimes, the shareholders bring in Mr New Talent to get the business ready for sale. The intention is the premium reward is made when the business is sold. Growth shares, another name for alphabet shares, can fit the bill.
- A growth share, for example E shares, can provide that the New Talent is only entitled to share in capital upon a sale of the business. New Talent does not have voting rights and does not have an entitlement to income. The amount of capital New Talent receives on his growth shares can be designed to fit in with the total value for which the business is sold.
- Growth shares are sometimes referred to as flowering shares. If there is no flower – i.e. exit – then the shares have no value.
- Payment can be layered to encourage efforts to achieve the highest price possible for other shareholders.
- A timescale for achieving sale can be fixed. The rights to capital can be fixed under the alphabet share to lapse on an expiry date. The rights attaching to other classes of shares held by shareholders (in this example the A, B, C and D shares) need not be impacted.
Alphabet shares – tax
The rate of tax payable on dividend income voted on an alphabet share is less than the comparable rate of tax for most salaries. And, at the moment up to £5,000 of dividend income can be paid tax free to anyone. This means that employees and directors can be voted tax free payments.
HMRC anti avoidance measures
If you award shares to employees or directors and pay them dividends to avoid tax on bonuses, HMRC may demand the employer pays PAYE and National Insurance. HMRC has a vast array of anti-avoidance measures at its disposal.
The dividend payments can vary between the different groups of shareholders holding alphabet shares for many reasons. A sound reason is risk and reward. The key is to consider and document these reasons before voting dividends on different classes of shares. Many SME’s are not fantastic record keepers. If HMRC challenges the payments, a lack of records counts against you. Yet, the paperwork need not be complex. Nevertheless, it must be prepared for the relevant board meetings.
Keep a record of decisions relating to alphabet shares
If HMRC challenges the dividend payments, they first ask for the paperwork. This includes the board minutes which approved the creation of new shares and the dividend payments.
Alphabet shares can be gifted
If you gift or transfer alphabet shares to employees and directors at a price below “tax market value” then HMRC regards this as a benefit in kind, and taxes the benefit. If the recipient pays at least the tax market value, there is no benefit in kind, so no tax to pay on receipt of the shares.
The benefit here to alphabet shares is tax market value is often much lower than the actual commercial market value.
Alphabet shares – tax market value
Private company valuations are not straightforward. Valuations involving alphabet shares (or restricted shares, freezer shares, growth shares and flowering shares) can be more complex. This is because each share class enjoys different rights and restrictions bringing different values. The valuation determines the deemed benefit on which employees or directors pay income tax and sometimes National Insurance.
Discount to a commercial value
HMRC accepts discounts to a commercial valuation that acknowledge:
- Minority shareholdings;
- Restrictions on the shares – alphabet shares, restricted shares, freezer shares, growth shares or flowering shares can all carry different restrictions compared to the rights attaching to the ordinary shares;
- Start-up, compared to an established trading company;
- Fluctuating profits.
Anti-avoidance rules impose additional income tax charges if employers do something that increases or changes the employees share’s value. Typically these are restrictions or conditions which affect the share’s value at the time of the award or after.
Payment of tax on an alphabet share gift or award
The rule of how and when tax has to be paid on the value of the alphabet share awarded depends on whether the shares are “readily convertible assets” when employee or director received the shares.
Readily convertible assets and quoted shares
If shares are readily convertible assets they count as earnings subject to PAYE and National Insurance. Readily convertible assets means the shares could be sold on a recognised stock exchange, or trading arrangements exist to covert the shares into cash. So, if an employer creates a guaranteed exit plan, e.g. agrees to buy the shares this counts as a trading arrangement.
If shares are not readily convertible assets, the employer does not apply PAYE. However, employees pay income tax under self-assessment by the 31st January after the tax year. National Insurance is not due on the issued shares, if there are no trading arrangements. Most private company shares are not readily convertible into cash as there is no market for the shares.
How to issue alphabet shares
The Companies Act 2006 contains several provisions to consider:
- Do the directors have authority to allot?
- Is there sufficient share capital to allot?
- Will any existing shareholders waive their right to automatic allotment, called waiver of pre-emption.
You will need to document, shareholders’ approval. Approval may require over:
- 50% of shareholders to vote in favour; or
- 75% to vote in favour, depending on the nature of the resolution.
Existing articles of association
We recommend a review the company’s articles of association. The rights attaching to any class of shares (including alphabet shares, restricted shares, freezer shares, growth shares or flowering shares) have to be set out in the articles. You may need to pass an appropriate resolution to grant the board authority to:
- Allot shares;
- Exclude statutory rights, because:
- Existing shareholders have statutory rights of pre-emption on new shares.
- Reclassify existing shares into new classes;
- Change the share’s nominal value;
- Create new share classes;
- Make bonus or rights issues.
Alphabet shares under a shareholders agreement
A shareholders’ agreement is a private agreement amongst the shareholders. All shareholders must agree to amend the shareholders agreement. The shareholders’ agreement can impose restrictions on:
- Introducing new share classes;
- Certain pre-emption rights;
- Altering share capital;
- Sale and transfer of alphabet shares.
We do work through requirements and recommend workable clauses for the actual situation. What is best, depends upon the personalities and objectives behind the creation of alphabet shares.
Alphabet shares held by minority shareholders
Often one or two shareholders, who together own the company outright, are used to making unfettered decisions. There is a culture change when additional shareholders have voting rights.
Minority shareholders often enjoy protections embedded in the shareholders agreement and articles off association. Private companies that create new share classes risk creating complications for existing shareholders. For instance the result is shareholder disputes over minority shareholder rights.
Helen Curtis is a member of the commercial team. Helen designs alphabet share structures and has a particular skill in drafting bespoke articles of association. We implement a wide range of solutions for a wide range of business needs.