In this guide to growth shares, we consider what growth shares are and how they can be used to incentivise employees (and others) and allow them to join in the growth in value of a company, in a tax efficient way.
What are growth shares?
Growth shares are a special class of incentive shares, often issued to employees, which only hold value if the company’s share price exceeds a ‘hurdle price’. Generally, they will not confer voting or dividend rights, and will usually be limited to participation on an exit event i.e. on an initial public offering or sale of the company. On issue, growth shares have a low or even nominal value, as they only have any value once the hurdle is exceeded. For example, if a company is currently valued at £8 million, the shares could set a hurdle which provides that the holders of the growth share will only get part of any exit proceeds above £10 million.
As a result of the low issue price these shares are a more affordable option for employees to invest in the company, compared to ordinary shares. This is because if they were sold at the point of issue, the growth share would not entitle the holder to receive any proceeds. Also, these shares minimise dilution for existing shareholders, as dilution will only occur once the value of the company exceeds the hurdle.
Growth shares can be used in conjunction with, or separately to EMI options. They can be used as an incentive to hire and retain employees who don’t qualify for EMI options, without the tax liabilities arising from issuing shares – a win for both the company and employee. Unlike EMI options, growth shares do not need to be exercised within 10 years of them being granted, and so may be another option for companies who do not envisage an exit event within that timeframe.
How growth shares work
- Let’s assume that the company’s ordinary shares are currently valued at £1.
- The company issues growth shares to an employee, at a hurdle of £2 per share.
- The company is sold five years later, at a price of £5 per share.
- Each holder of ordinary shares will receive £5 per share, whereas the holders of growth shares will only receive £3 per share i.e. the excess over the hurdle.
- If the company is sold for a price less than £2 per share, the holder of the growth shares would receive nothing.
Setting up a growth share plan
- 1. Obtain a valuation of the company
The company will need to be accurately valued in order to determine the market value of the shares.
- 2. Update the company’s articles of association
Amendments will need to be made to the company’s articles to create a new class of growth shares.
- 3. Obtain shareholder approval
Shareholder approval will be necessary to amend the company’s articles and issue the shares.
- 4. Create the growth share plan & subscription agreement
These will establish the rules on how the company will issue the growth shares, provide details of the hurdle threshold and any conditions attaching to the shares.
- 5. Issue shares
The participating employees will need to pay cash in return for the growth shares unless the cost is being deducted from their salary, in which case, any income tax payments will need to be calculated.
Advantages and disadvantages
- Growth shares are issued at a low cost to the employee;
- There is no immediate dilution for the existing shareholders;
- They are an attractive incentive for employees to work hard, stay committed to the business and be aligned to its long-term growth ambitions;
- The company can issue as many growth shares as it likes – to whomever it wants, within no set time limit; and
- They can be conditional, for example, be based on performance targets.
- If the hurdle threshold is not met, the growth share will never have any actual value and upon a company sale they would receive nothing;
- HMRC will not agree to approve a valuation of the shares (unless used in conjunction with an EMI option scheme), so a valuation (at a cost) will need to be obtained each time growth shares are awarded.
- Employees are required to pay upfront for the shares – and may be liable for income tax and national insurance, on any discount given on the market value of the growth shares. This should not be a concern in practise, as the value for these shares will be minimal; and
- Changes to the articles of association requires shareholders consent.
What happens if a holder of growth shares leaves the business?
Typically, 'good and bad leaver' provisions will be included in the company's articles of association to govern what happens when a holder of growth shares leaves the company. Generally, a 'good leaver' (for example, an employee who is leaving due to ill-health) would be able to retain their shares, whereas a 'bad leaver' (an employee whose reason for leaving could be more contentious) would be under an obligation to sell or forfeit those shares. However, these provisions will be tailored to each company's needs.
The tax treatment of growth shares will depend on a variety of factors, including:
- the price at which the shares are purchased relative to their market value;
- the length of time the shares are held;
- the holder’s relationship with the issuing company;
- the residency and domicile status of the holder; and
- whether the shares remain within the restricted securities regime.
That said, growth shares are usually structured to allow the holder to benefit from capital treatment, paying capital gains tax on the difference between the price at which shares are acquired and the price at which they are sold. It may also be possible for the holder to benefit from business asset disposal relief, further reducing the tax payable.
Before putting any growth shares in place, it is worth considering whether the shares can be delivered to employees via a tax-advantaged option scheme. This usually does not change the tax treatment of the disposal of shares by the employee, but allows the option holder to defer paying for the shares until the option is exercised (leaving the commitment virtually risk free) and still only pay for the shares at their market value when the option was granted without additional tax liability.
This advice should be taken early on in the process as tax-advantaged schemes are not suitable or available for all companies, and even very small changes or errors can result in an income tax charge on the exercise of the option and/or the subsequent disposal of the shares.
How we can help
Our corporate team can provide expertise advice, tailored to your business, on which share schemes are appropriate based on your company’s long-term goals. We can assist you in establishing a suitable growth share plan, and advise on other available share schemes, including EMI share options.
Enjoy That? You Might Like These: