Growth shares award
Gannons enabled a company to take advantage of growth shares to motivate a key director and limit the tax exposure.
Our client was a former start-up who wished to award their sales director more equity in a tax-efficient manner. When he first founded the business, the director was the majority shareholder. Over the years though, this 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.
Motivations behind the growth shares
The business already provided cash bonus incentives and was looking for additional ways to incentivise its employees. 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. Therefore the motivation had to be a free benefit for the director.
Our client came to us to find out what the best options to provide the necessary incentive would be.
Why award growth shares?
There were many options to explore. We went through a process of elimination and concluded that growth shares award suited our client’s needs best.
EMI options (Enterprise Management Incentives) are the most commonly used employee incentive scheme. However, in this case the group did not qualify for EMI options because it did not control all of its overseas subsidiaries. Furthermore, the director’s existing shareholding exceeded 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. However, awarding the director ordinary shares would have incurred income tax liability based on the unrestricted tax market value of the shares on the date of award.
The group felt that given the potentially unrestricted tax market value of the shares, they needed to look at the forward projections for the business. This would lessen the liability for the director more so than looking at past performance.
There was still a risk for the director that HMRC would not refund the income tax he had paid upon receiving the shares. This would occur in the event that the group did not meet HMRC’s forward profit projections, and the ordinary shares failed to reach the unrestricted tax market value set.
Addressing our client’s needs
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 board only intended to provide the director a greater portion of the proceeds from the future sale of the business than his current shareholding permitted. As such, the director would forfeit his shares if he left the business before such a sale.
Solution: growth shares
We designed a new class of shares: growth shares. These did not bear dividends, did not confer voting rights, and only distributed capital if the business was above a certain value We amended the articles of association and the shareholders’ agreement to create the growth shares and dealt with reporting at Companies House. The shareholders needed to approve a special resolution that dealt with the changes.
The director needed to settle the income tax arising upon awarding the growth shares. However, compared to ordinary shares, the growth shares greatly limited the director’s liability.
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.
This was necessary to provide evidence to HMRC that the value of the shares was unknown at the time of their awarding. This is important in the event of the company being sold shortly after awarding growth shares. A detailed valuation report, in addition to 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”. This avoids the risk that HMRC assesses the profits coming from the sale of the growth shares as income tax rather than capital gains tax.
Result of awarding growth shares
Since becoming a shareholder the employee has exceeded all of his sales targets and the company has become more profitable. Awarding the shares meant that the interests of the company and the employee became more aligned with one another. 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.
Gannons did astonishing work to address every one of our problems and find the perfect solution.