Growth shares before business sale

Case study background

 The company is a long established trading group operating several different businesses and controlled by a sole shareholder.  The key design issue was to ensure that senior executives and selected employees (participants) were offered an equity incentive that would only deliver value on exit.  In addition, the company wanted to ensure that participants were able to realise their share sale proceeds at capital gains tax (CGT) rates instead of at higher rates of PAYE/NIC.

Using growth shares was seen as the preferred alternative because growth shares align the interests of the sole shareholder with the reward to participants if the ‘equity hurdle’ (see below) was achieved on exit.  The shareholder and board of directors agreed that the growth shares would be entitled to 20% of the value achieved on exit above an equity hurdle.

The equity hurdle was set at 120% of the commercial value of the company and was determined at the date participants were granted their incentives. Insofar as the exit sale proceeds exceed the equity hurdle, participants would be entitled to 20% of the excess, with the current sole shareholder entitled to the remaining 80% plus all value below the equity hurdle.

Example (1) 

  • The commercial value of the company at the date growth shares are granted is £8 million. 
  • The equity hurdle is set at £9.6 million (which is 120% of £8 million).
  •  The company obtained a tax valuation of the growth shares at the date shares are awarded of £0.10 per growth share. 
  • An incentive pool of 120,000 growth shares was created for the award of growth shares to 10 employees. 
  • Employees paid a subscription price of £0.10 per growth share on award.

 On an exit occurring three years later, the company was sold to a cash purchaser for £14.6 million.  The equity hurdle was achieved on exit and holders of growth shares receive 20% of the proceeds obtained above the hurdle, but no value below the equity hurdle – which is for the benefit of the non-growth shareholders, who also share in 80% of the value above the equity hurdle. 

Some holders of growth shares left before exit (see below Leavers) and 100,000 growth shares (out of the original pool of 120,000) were sold to the purchaser on exit.   

Each growth share in issue is entitled to receive £8.33 of the exit proceeds, equal to – 

£833,333 in total (i.e. 100,000 growth shares in issue) = (£14.6 million – £9.6 million) x 20% x (100,000/120,000) 

Leavers:

 Some employees left the company in the period before exit. The company’s board of directors exercised its discretion to allow good leavers to retain a percentage of their growth shares and participate in the exit, with the remaining shares re-purchased by the company at cost (£0.10 per growth share) and cancelled. 

On exit the share sale proceeds due to all holders of growth shares was ‘scaled back’ by the fraction 100,000 / 120,000.  This was done because there were fewer growth shares in issue on exit (100,000) than it was expected when the incentive pool of 120,000 shares was created. Without scaling back the proceeds per growth share would have been greater, without any additional performance by growth shareholders.   

Tax on sale of growth shares: 

Employees paid CGT on sale of their growth share on a gain of £8.23 per share (=£8.33 – base cost of £0.10) and were able to use their CGT annual allowance.  

Employees were not eligible for Business Asset Disposal Relief (BADR) because they did not qualify in relation to their shareholdings in the company.  (BADR is discussed below in relation to granting EMI options over growth shares).

Also because the company was eligible to grant tax advantaged EMI options, it was decided to grant EMI options over growth shares (with the option exercisable on exit).  This allowed the company to agree a valuation of the growth shares with HMRC for the purpose of granting EMI options over growth shares.  This provided certainty for the company and participants that:

  • the exercise price payable per growth share was not less than market value (as determined on the option grant date); and
  • no PAYE/NIC should be due on option exercise (immediately before exit) or on sale of the growth shares.

If the company had not been eligible for EMI it could instead have offered participants the opportunity to buy growth shares. This would broadly achieve a similar outcome for participants, on sale of the growth shares, assuming market value is paid up-front for the shares.  However, one of the benefits of using EMI options is that EMI acquired shares may benefit currently from a 10% rate of CGT on share sale (on £1m of gains under BADR.  This applies if EMI acquired shares are sold at least 2 years after the option grant date. If BADR is not available, gains on sale of growth shares will be taxed currently at 20%.

Example (2) 

Using the same facts in Example (1), except the company granted EMI options over growth shares at an exercise price of £0.10 per share.  The company agreed with HMRC that the grant date valuation was equal to the market value of a growth share on exit. Options were granted on terms they were only exercisable on exit. 

Employees exercised their options immediately before exit and sold their shares to the purchaser. 

Income tax relief was due on exercise of EMI options (i.e. on the amount by which the exercise price of £0.10 exceeded the sale price per share of £8.33).  

In addition, employees who sold shares were eligible to claim BADR relief on their gains on sale of shares.  The chargeable gain per share was £8.23 (=£8.33 less a base cost of £0.10 per share). 

Leavers: 

Leavers who retained options and exercised their options on sale, were partly subject to PAYE and NIC on exercise of their options (i.e. they did not receive income tax relief in full on option exercise).  This is because cessation of employment is a disqualifying event for EMI purposes.  As a result, PAYE and NIC was due on exercise of option on that part of the growth in value of a share in the period between 90 days after cessation of employment and the eventual exit date. 

Leavers were not eligible to claim BADR on exit because they did not meet the qualifying conditions and ceased employment prior to exit.  In calculating a Leaver’s chargeable gain on sale of shares, their base cost per share was: the exercise price of £0.10 per share plus the amount on which income tax was paid on option exercise per share.

Catherine Ramsay

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Catherine Ramsay

Manages to explain difficult concepts in easy to understand language. In tune with her clients.

Let us take it from here

Call us on 020 7438 1060 or complete the form and one of our team will be in touch.