Growth shares

Growth shares, flowering shares, waterfall shares & hurdle shares can be an effective way to provide shares for employees and directors. Growth shares are particularly attractive in high growth companies where by providing shares to employees it is hoped they enjoy the capital growth on sale.

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To help you decide if growth shares are an idea for you we have set out a brief guide.

Benefit of providing shares to employees as growth shares

Growth shares are popular with private companies as a means to provide shares to employees to incentivise them to grow the business and share in capital profits on the sale of the business.

Usually growth shares are provided to employees by way of newly created class of shares designed to deliver the specific results required.

Tax benefit of growth shares

Growth shares take advantage of the fact that the rate of capital gains tax, when the growth shares are sold, is less than if the equivalent benefit was provided as salary which is subject to income tax and national insurance.

Most popular use of growth shares

Growth shares are most commonly used to provide shares for employees where:

• Ordinary shares are too expensive for employees to purchase outright; or
• The business or the recipient does not qualify for traditional HMRC approved incentive schemes, e.g. EMI options; or
• The company wants to offer incentives to non-employees, such as consultants or non-executive directors.

Growth shares are often implemented by:

• High growth companies with an exit plan (early stage companies usually implement EMI options if the qualifying conditions for EMI are met. This is because EMI options offer better tax benefits.)
• Companies looking for alternatives to HMRC approved share options such as CSOP and SIP. For example, the employer may wish to make larger awards of shares to employees than that which can be provided under a CSOP or SIP. Or, the group may have subsidiaries which disqualify it from providing shares to employees under any of the HMRC tax favoured share plans including the EMI scheme.

Flexibility of growth shares

Growth shares are flexible. What is more, participation can be selective. This means that the employer does not have to offer growth shares to every employee or offer to every participant on equal terms.

The share rights attaching to growth shares 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. The share rights will be set out in the articles and/ or shareholders agreement.

Acquiring growth shares

The price at which the participant invests in growth shares is a matter for the board and shareholders to determine at their discretion. The growth shares can be provided at no cost. Alternatively, growth shares can carry an acquisition cost if it is intended to see the employee only benefit in growth value above a certain threshold or if the recipient is required to invest in the business.

Ways in which growth shares can be used

There are many types of variety of growth shares. Common types of ideas revolve around:

• Traditional growth shares –  entitle the shareholder to benefit only from the growth in the value of the company above a “threshold” or “hurdle” which is specified on issue. On issue the company has not achieved the growth and therefore the growth shares are likely to have only nominal value. However HMRC often takes the view that the growth shares have a “hope” value over and above the “intrinsic” value of the share.
• Future hurdle growth shares – allow the growth share holder 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. It is not unusual to see flowering shares and hurdle shares combined.
• Flowering growth 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 or sale of the company above a defined value.
• Waterfall growth 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 – growth shares designed with a ratchet entitle existing shareholders to an enhanced entitlement to shares, if the company achieves particular performance targets.

Interaction of growth shares with SEIS and EIS

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 can cause other shares to inadvertently obtain 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 SEIS or EIS assurance.

Tax implications with growth shares

If employees or directors acquire growth shares they will be liable to tax:

• If the employee pays less than the unrestricted tax market value for the growth shares (see the illustration below);
• When any restriction is lifted or varied; and
• In some cases when the growth share is sold.

Preserving capital treatment on sale or transfer of a growth share

A section 431 election will protect capital treatment on the sale of shares.

Imagine the employer provides shares for employees via a growth share offering the opportunity to subscribe for 1 growth share at £1. The growth share carries no rights to dividend and only attracts a capital payment if the company is sold within a limited time frame. The unrestricted tax market value of the share is £40. But taking into account the restrictions, the actual value is say, £20. The company is private and has not received any offer for sale. In four years time there is an exit at £100 per share.

On award of the growth share the employee can elect to be taxed on the £40 unrestricted tax market value, i.e the value of the growth share on an unrestricted basis on acquisition. Any value growth is then subject to capital gains tax. The employee will have to pay tax calculated on the £40 unrestricted value as well as the £1 subscription price.

But having made the section 431 election the gain on sale which is £60 (sale price less the amount already assessed to income tax) is taxed as capital. Without the election, the benefit could have been subject to income tax and national insurance.

The section 431 election must be entered into within 14 days of the acquisition of the growth shares.

There are tax reporting requirements for both recipients and employers.

Growth share implementation

Providing shares for employees as growth shares does require some planning.

Typical areas to think about include:

• The company’s current valuation – this is usually not straight forward in private companies pre exit. The exercise of valuing unquoted shares is subjective in practice.
• The company’s likely growth and timescales.
• Impact of dilution created by the growth shares on other shareholders.
• How much benefit, is it planned, is passed to the employee or director via the provision of growth shares.
• Obtaining shareholder approval for the amendment to the articles is needed for the creation of the new class of growth shares.
• How to deal with leavers – see below.
• Communication with the growth share recipients about the tax reporting and payment implications.

Rate of capital gains tax payable on sale of the growth share

Providing shares to employees as growth shares can qualify for Business Assets Disposal Relief (entrepreneurs relief). However the qualifying conditions for Business Assets Disposal Relief (entrepreneurs’ relief) will have to be met.

Leaver provisions

Consideration is needed about what happens if the employment is terminated. It is possible to require the shares to be transferred providing provisions have been included in the articles or shareholders’ agreement. If no provision is made, the recipient will retain his growth shares post termination.