What is the purpose of growth shares?
Growth shares are used in employee incentive planning.
They are often considered when an employer does not qualify for one of the tax advantaged share option structures.
Growth shares offer an alternative means to get equity into the hands of employees without a significant Income Tax charge.
They enable the employee to participate in the future growth of the company and the employee’s profit to be taxed at Capital Gains Tax rates (rather than the higher Income Tax rates).
What are the potential tax advantages?
When employees are provided with valuable shares in their employer they are potentially subject to an Income Tax charge (and possibly a national insurance contribution (NIC) charge). This is because they are treated as receiving taxable remuneration to the extent they pay less than full market value for the shares.
For instance, if an employee was issued with £20,000 worth of shares in his employer, and did not pay anything for these shares, he would be subject to Income Tax on £20,000.
To avoid upfront Income Tax and NIC charges, employees need to pay for their shares in full. Unfortunately this means that if the employer was a well-established and valuable business the employee would either have to find a substantial sum of money to invest or bear a significant Income Tax charge.
Growth share planning offers a potential solution to this problem.
The principle behind growth share planning is to create a new class of share capital that has a comparatively modest value when it is first issued.
Ensuring that employees are able to afford the full market value of the shares when they are issued (which is usually a very modest amount) means that there should be no tax charge to pay at that point. Any future growth should be subject to Capital Gains Tax only rather than Income Tax. The rates of Capital Gains Tax are generally much lower.
How are growth shares structured?
Growth shares involve the creation of a new class of equity that provides the employees with the right to participate in future growth in value of the company but with no right to share in any of its current value.
As an example, imagine that a small family company is currently worth £10m. The company has one class of ordinary shares and all the shares are held by the founder and his close family. The founder wishes to incentivise some of the senior managers. Rather than issuing them with ordinary shares, the founder decides to issue the managers with growth shares that would entitle them to 10% of any sales value in excess of £10m. If the company was sold three years later for £15m then the holders of the growth shares would only be entitled to £0.5m in total (i.e. 10% of the £5m growth since they were issued). If the founder had issued the managers with 10% of the ordinary share capital instead, they would have been entitled to £1.5m (i.e. 10% of the total sales proceeds).
The fact that the shares do not participate in any of the existing value of the company when they are first issued explains their modest initial value. In our example the company is currently worth £10m and the growth shares are only entitled to a share of any sales proceeds in excess of £10m. They will only stand to benefit if the company grows in value. This cannot be guaranteed, so they only have so-called “hope value” at issue.
Often growth shares will also incorporate a “hurdle”. This means that the threshold at which the growth shares begin to participate is set at a figure above the market value of the company when they are issued. For instance, in our example of the family company, the growth shares could be designed so that they are only entitled to share in any sales proceeds above £12m.
What sort of company might consider growth shares?
The growth share concept works best for private companies, particularly start-up companies with a low current value but substantial future growth prospects.
Growth shares are not really suitable for listed companies. They require a separate class of share capital to be created and this is not feasible for listed companies. However, it may be possible to engineer a similar economic result for a listed company using a Joint Share Ownership Plan” (see our other briefing note on JSOPs for more details).
Growth shares are usually considered when the employer does not qualify for one of the tax advantaged option plans such as EMI or CSOP options. For example many private-equity backed companies, and joint ventures, are not eligible to grant EMI or CSOPs options as they fail the “independence” requirement for these plans.
Nevertheless, even some companies that do qualify for EMI look at growth share planning. In some circumstances it is possible to leverage the tax advantages of both types of structure.
Shares acquired from the exercise of EMI options are more likely to qualify for entrepreneurs’ relief. This is because the usual conditions for this relief are relaxed for shares acquired via EMI options (e.g. there is no need to hold a 5% stake in the company so even smaller minority interests should be eligible). Granting an EMI option over a new class of growth share may therefore help secure the benefit of entrepreneurs’ relief for the growth share in addition to the tax advantages of the growth share outlined above.
Two other possible advantages to combing growth shares with EMI are:
- EMI options only qualify for full EMI tax benefits to the extent that the option exercise price is set at a sum greater than the market value of the shares when the option is granted. Granting EMI options over a new class of EMI may mean that the exercise price can be set at a lower level; and
- it may enable the full growth in value of the growth share to become eligible for a Corporation Tax deduction for the company. Corporation Tax relief is generally available when an EMI option is exercised on the difference between the exercise price paid by the employee and the market value of the shares at that point (a growth share issued outside an EMI option would only qualify, at most, for such a deduction in relation to the initial value of the growth share).
How could Fladgate help?
Fladgate has considerable experience in establishing growth share arrangements and we are well placed to assist with both the legal and the taxation aspects of growth share arrangements.