Implications of becoming an employee shareholder

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Gannons advised an employee upon a deal he was offered to become a shareholder in his employer’s company.

Our client was invited to become an employee shareholder in his employer’s company, which designed and built robots. Our client was not sure about the value of making such a move. He was also worried about being asked to sign a “Section 431 election”.

The problem

The documentation issued by employers when they gift shares to employee shareholders can be long and very legalistic. It can therefore be hard for an employee to understand the meaning and assess the potential value. Without knowledge of the value in such offers, employees cannot assess the real benefits and understand the risks.

Our client was offered a mix of low salary and free shares in the business. He was unsure whether it was a good deal.

The outcome

Talking the offer through with our client enabled us to advise him on areas where the value in the offer could be improved upon.

How to assess the potential of shares

We explained a number of key issues an employee shareholder should consider. The major issues were:

What happens if the employee leaves employment?

The employee shareholder conditions set out in the shareholders agreement provided for the forced transfer of shares on leaving employment. There was a price formula in the agreement setting out the price at which the shares will be bought back on leaving.

Good and Bad leaver clauses

The shareholders agreement made a distinction between a good and a bad leaver. Leaver clauses are common. If our client left the company because of death or disability, he would be considered a good leaver. As a good leaver he would receive a fair value for his shares on leaving. But, if he resigned or left for any other reason, including redundancy, as drafted he would be a bad leaver. As a bad leaver he would get nothing back. We set about changing this.

We negotiated a better position for the client. If he stayed with the business for over a year he would always be considered a good leaver. Although in the event that he was dishonest, then he would be considered a bad leaver. We advised that this was a reasonable event to attach to a bad leaver.

What happens if a dividend is paid?

The shares being given to the employee were a separate class of shares. This meant that he might receive a lower rate of dividend than other shareholders. We advised that it should be agreed that the dividend voted on his shares would always be equal to that voted on other classes of shares. A perk of being a shareholder is that under current law the first £5,000 of dividends is tax free.

What happens if the business is sold?

The shareholders agreement included drag along provisions. Under these, if the business was sold the employee shareholder would have to go along with the business sale. He could not block the sale even if he did not like the sale price.

We advised including tag along provisions. Tag along enables a minority shareholder to also sell if an offer is made to the majority shareholder. They protect the employee shareholder.

How much tax is payable on receipt of the shares?

Gifted shares were taxable as income for the employee shareholder. Shares have a taxable value in the eyes of HMRC.

We suggested the employer obtains agreement from HMRC as to the taxable value. This was to give our client certainty over how much tax he has to pay on the gift of shares. We suggested that the employer loans the money needed to pay the tax due on the gift.

We warned the client that once the income tax was paid there will be no refund if the shares go down in value. Therefore we talked the employer into giving an indemnity to cover the risk of over paying tax.

Should an employee shareholder sign section 431 election?

A section 431 election is a document by which an employee shareholder and their employer choose to pay tax on the unrestricted tax market value of shares at the time of the grant, regardless of price paid for the shares by the employee shareholder. Signing it secures certainty on the tax treatment for the employee as we show below. We recommended that the section 431 election was signed.

Section 431 election – Illustration

If no section 431 election is entered into there is a risk that HMRC will assess the shares at a higher value. For example, if HMRC place a 20% undervalue on the shares, then 20% of shares sale price will be subject to income tax on sale. As we explain below a section 431 charge can reduce the overall tax burden.

If a section 431 election is signed and tax paid on the gift of shares there will be no income tax or NICs on sale of shares. No nasty surprises for the employee shareholder. The effect of the section 431 election is that the growth in value is assessed to capital gains tax. Capital gains tax is lower than income tax and NICs.

What happens if the employee wants to set up his own business in the future?

The employee shareholder was bound by anti-competition restrictions. These meant that he could not set up in competition for a year after he left. We successfully negotiated the restrictions down to 6 months.

Can the employee shareholder stop his shareholding from being diluted?

The employee shareholder was worried that new investors could dilute him in the future. This could cause his shareholding to drop below the entrepreneurs relief 5% threshold.

However, we explained that all shareholders are at risk of dilution, and whilst legally possible, it is rare to ring fence shareholdings. The idea is that new shares are issued to improve the value of the company. Whilst the shareholding may drop in terms of the total percentage of the company owned – following dilution, the shareholding is over a more valuable company. Therefore, as a workaround we suggested the employee shareholder was given some powers of veto to prevent certain actions being taken without his approval.

Veto powers

Our client gained the power to veto any bank borrowing over £50,000, as well as the company giving a guarantee or a loan to anyone outside the normal course of business. He could also veto the board approving a dividend that exceeds 40% of post-tax profits. Our client could also veto the appointment of a director or an employee whose salary would exceed £100,000 gross per annum.

How much influence does the employee shareholder have?

The employee shareholder was offered 10% equity. However, Minority shareholders do not have a lot of power. For instance, a 10% shareholder could not block a special resolution.

Our client’s powers

Our client’s shareholding meant that he could ask for a general meeting be held and propose a resolution at a general meeting. Further to that, he could block holding a general meeting at short notice. He could also require that the company circulates a statement to shareholders relating to proposed resolutions to be discussed at shareholders’ meetings. Finally, he could prevent the deemed re-appointment of the company’s auditor.