Growth shares, flowering shares, waterfall shares & hurdle share can deliver effective incentive schemes. If you have established a viable business, and want to incentivise key employees, then growth shares are a useful tool.

Benefits of growth shares

Growth shares entitle employees or directors to participate in growth of the business but usually on restricted terms. Growth shares are most commonly used where:

  • Shares are too expensive for employees to purchase outright as ordinary shares; and or;
  • The business or the recipient of shares does not qualify for traditional HMRC approved incentives, e.g. EMI options.

Growth shares schemes are often implemented by:

  • High growth companies with a clear exit plan;
    • Note very early stage companies usually implement EMI options because the value of shares has not started to grow substantially. EMI options offer employers and employees more benefits, yet can be used to achieve the same results.
  • Companies looking for alternatives to HMRC approved share incentives. For example, with the restriction of benefits attaching to employee share schemes we see employers looking to growth shares.

Growth shares: Flexible

Growth shares are flexible. Your scheme’s design is not restricted. What is more, participation is selective. This means you do not have to offer growth shares to every employee or offer every participant equal terms.

Growth shares: Cost

The price at which the participant invests in growth shares is a matter for the board and shareholders to determine. The growth shares can be free to acquire. Alternatively, growth shares can carry an acquisition cost if it is intended to see the employee investment more than just time in the business.

Growth shares: Rights

The design of share rights, i.e. rights to voting, dividends and capital are at the discretion of the board and shareholders. The delivery of rights can be phased over time or restricted – there is plenty to think about.

Growth shares: Tax efficient

If you give shares, either for free or at discounted values to employees or directors, then they receive an employment benefit. That benefit is subject to income tax and sometimes national insurance.  However, if the value of the shares for tax purposes on the day of the award is low, then the employment benefit and taxes are low.

The gain on sale is subject to capital gains tax rather than income tax.   Capital gains tax carries a lower rate of tax than income tax and national insurance.

Types of growth shares

There are many types of growth shares. The type of share used is tailored to the specific company and participant requirements. Common types of ideas revolve around:

Flowering shares

Flowering shares only become valuable if and when the company achieves specified performance conditions. The performance conditions are usually tied to capital growth business objectives, e.g.:

  • Turnover targets;
  • Sale of the company above a defined value.

Hurdle shares

Hurdle shares allow the shareholder to benefit only from growth in the value of the company above a future hurdle amount which usually exceeds the current value of the company at the time of share award. The hurdle can be a variety of objectives the business needs to meet on its way to an exit. Hurdle shares are often used as an interim reward before the big reward on exit. It is not unusual to see flowering shares and hurdle shares combined.

Waterfall shares

Waterfall shares allow a shareholder to participate in the value of the company after certain other shareholders have been paid off. Waterfall shares are focused on the distribution of gains following an exit. They work like a set of buckets, after one gets full, the other fills up. The advantage is that the sooner the other shareholders are paid off, the bigger the pay out to the waterfall shareholder. Waterfall shares are often used as top slicing incentives.

Performance ratchets

Technically, performance ratchets are a characteristic of growth shares, not a type of growth share. Ratchets entitle existing shareholders to shares, if the company achieves particular performance targets. Ratchets are a contractual right to acquire future shares included in the Articles of Association.

Interaction of growth shares with EMI, SEIS and EIS

Smaller, private companies can grant EMI options over growth shares. EMI options remain the first consideration.  However, mature companies, who don’t qualify for the EMI options can sometimes put growth shares into an EMI scheme, when the option’s value is less than the value of ordinary shares.

SEIS, EIS and growth shares

Growth shares can negate SEIS and EIS qualification status. SEIS and EIS shares cannot carry:

  • Preferential rights on winding up;
  • Preferential dividend rights.

Growth shares often carry preferential rights. Call us to discuss whether you qualify for SEIS or EIS if you want to use growth shares before you apply for an advance assurance.

Restricted securities: tax implications

A restricted security is a share whose value is reduced by restrictions attached to the share. Not every restriction makes a share a “restricted security”, e.g. private company shares are not “restricted securities”, but are inherently restricted since there is no market for the shares. Often, private company employees and directors acquire restricted securities under share schemes. Many growth shares are restricted securities.

The Articles of Association usually contain details of the restrictions. However, a contract or even an unwritten arrangement can include details of the restrictions. Employees may not realise their shares are restricted and may incur surprising income tax charges.

Restricted securities tax

Restricted securities have two values for tax purposes, the:
1. Actual, restricted tax market value: the share valuation accounting for all restrictions;
2. Unrestricted tax market value: the share valuation disregarding the restrictions which forms the basis of tax.

Circumstances of tax

If employees or directors acquire a restricted security as a part of an employment package, they can be liable to income tax:

  • If the employee pays less than the unrestricted tax market value for the security.  HMRC charges income tax when the employee acquires and/or sells the security, depending on the security’s restrictions;
  • When the restriction is lifted, varied, or the share is sold;
  • If the employee pays less than the unrestricted tax market value for the security;
  • When the employee disposes of the security for less than the acquisition price.

Managing liability

A Section 431 election helps manage the employee’s tax liability when restrictions are lifted and on the sale of shares. If the election is made validly, employees can avoid tax liabilities that arise after the award. For example:

Imagine, you offer your employee the opportunity to subscribe for 1 share in your company. The unrestricted tax market value of the share is £40 whilst the actual, i.e. restricted market value is £20.

The employee can elect to be taxed on the £40 unrestricted tax market value, i.e. the benefit on acquisition. Any value growth is then subject to capital gains tax, not income tax that arises during the life of ownership if restrictions are lifted.

Growth share scheme implementation

We resolve the following issues:

Before setting up the scheme

Typical issues include:

  • Company’s current valuation
  • Company’s likely growth
  • Timescales
  • Hurdle amount: i.e. the value at which growth shareholders cash in
  • Number of shares awarded
  • Growth share recipients
  • The chance that existing shareholders will consent to the proposed scheme

Growth share rights scheme design

Usually growth shares are a separate class of shares with different rights compared to ordinary and/or founder shares. We draft appropriate amendments to your company’s Articles and Shareholders’ Agreement. Key characteristics of growth shares include:

Capital and income entitlement

Growth shares typically rank below ordinary shares. So profits are first distributed to ordinary shareholders, then the growth shareholders.

When the business is sold, ordinary shareholders are usually entitled to a fixed amount. What’s left is distributed between ordinary and growth shareholders.

Growth shares typically have no or minimal dividend rights.

Voting rights

Growth shareholders usually have no voting rights. Sometimes, growth shareholders are granted enhanced voting to take advantage of entrepreneurs relief.

Leaver provisions

If the growth shareholder resigns or the company terminates their employment, then claw-back or buy-back provisions apply. These are documented in the Shareholders’ Agreement.

The share repurchase price usually depends on good and bad leaver clauses. In practice, if the growth shareholder leaves before the business sells, s/he is unlikely to be paid more than the subscription price.

Growth shares valuation

Usually, if an employee acquires shares, there is an income tax liability. The amount depends on the company’s valuation, on the acquisition date. The tax must be paid before the company is sold. Hence we negotiate and agree the unrestricted tax market value and the actual market value of shares with HMRC before the share acquisition.

Our growth shares track record

Recent instructions involving growth shares:

  • Designed performance-based growth share scheme that incentivised a medical recruitment consultancy’s incoming CEO;
  • Amended PR agency’s Articles of Association, who issued growth shares to two key employees;
  • Introduced a separate class of growth shares for a veterinary practice’s new shareholder;
  • Advising on the issue of equity involving a ratchet arrangement for a company specialising in electrical appliances.

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