Here we enabled a company to take advantage of growth shares to motivate a key director and limit the tax exposure.
Motivations behind the growth shares
Our client wished to award their sales director more equity in a tax-efficient manner. The director did have a substantial shareholding when the business was founded but over the years had been diluted down to around a 30% shareholding. The board wanted to retain and incentivise him to grow the business for an eventual exit.
The business was looking for an addition to its cash bonus incentive. Furthermore, the employer was part of a group running overseas subsidiaries and the board wanted the director to focus on the profitability of the entire group.
It was decided that the director should not be required to invest further in the business and therefore the motivation had to come in the form of a free benefit as far as the director was concerned.
The group was out of start up stage and had moved into profitability.
Our client wanted to know the best options.
Why award growth shares
We went through a process of elimination to arrive at the recommendation that growth shares were the best fit. There were many ideas to explore.
EMI options, for many the most common route, were ruled out. The group did not qualify for EMI options because it did not control all of its overseas subsidiaries. Furthermore, the director’s existing shareholding was in excess of the permitted levels under the EMI legislation.
Unapproved options and phantom options were ruled out on grounds of tax inefficiency.
Issue of shares
The group was keen to award equity on day one rather than promising to award equity in the future.
If the director had been awarded ordinary shares the award would have triggered an income tax liability based on the unrestricted tax market value of the shares on the date of award. It was felt that given the unrestricted tax market value would require looking to the forward projections for the business, rather than looking backwards, the income tax liability for the director could be substantial.
There was risk for the director because if the group did not meet the forward profit projections that HMRC would assume, and the ordinary shares failed to reach the unrestricted tax market value set, the income tax paid on award would not be refunded.
Solution the growth shares provided
The group’s dividend policy was to retain profits for growth. The board did not particularly want to confer the director with increased voting rights. The real intention was that the director shares in the disposal proceeds on the sale of the business to a greater degree than his current shareholding permitted. If the director left the business he was forced to transfer his shares.
We designed a new class of shares – growth shares – which were not dividend bearing, non-voting and only permitted a distribution of capital on the sale of a business above a certain level. We amended the articles of association and the shareholders’ agreement to create the growth shares and dealt with reporting at Companies House. The shareholders were required to approve a special resolution to deal with the changes.
The director was required to settle the income tax arising on award but the liability was much reduced compared to what would have been payable if ordinary shares were awarded.
Valuation of the growth shares for income tax purposes
We advised the board on the likely valuation which HMRC would agree and set out the rationale. This was an important step because it recorded the information available to the board at the time of the award. In practice, if the business was sold for a profit shortly after award it can be difficult to persuade HMRC that sale and the value was unknown as at the time of the award. A detailed valuation report plus board minutes go some way to establishing the position and securing a better tax position for the director.
We also explained the need for “Section 431 elections” to avoid the risk that HMRC assess profits arising on the sale of the growth shares to income tax rather than capital gains tax.
The story so far
Since the employee became a shareholder he has exceeded all of his sales targets and the company has become more profitable. The interests of the company and the employee are now more aligned. The company is prospering and is more confident that the director will not jump ship to a competitor. The director is looking forward to reaping the rewards upon a future exit.
Catherine Gannon regularly advises businesses based in the UK and overseas on the implementation of employee share plans including growth shares.