Growth Shares

by Fionnula Lynch, Jeremy Glover and Dan Pipe

Many smaller companies are able to grant enterprise management incentives (‘EMI’) options over shares – these can be extremely tax efficient but EMI is not available to all companies. Companies in many industries do not qualify under the legislation. There are also rules on the size of companies that can grant EMI options.

In addition, EMI options are options rather than shares and so, until exercise, employees are not entitled to dividends. Many companies want their employees to be shareholders from day one.

Growth or hurdle shares are an alternative tax efficient form of employee share incentive, particularly popular with tech start-ups. They enable senior employees and directors to become shareholders and participate in future growth for a low initial investment.

Growth shares are usually designed so that the shareholder only participates in share gains to the extent that a particular hurdle has been achieved. Structured correctly, share gains on growth shares should be subject to capital gains tax (“CGT”) rather than income tax treatment and National Insurance Contributions.

On an exit event, growth shares enable the employee to receive:
• a share of the increase in the growth in the company’s value above a hurdle which exceeds the current value of the company;
• value only if certain performance targets (usually an expected return to investors) are met. Sometimes growth shares are designed so that once a threshold is met, the shares receive a pro rata share of the entire sale.

The arrangements require a new class of shares to be issued. The new or revised articles should set out any voting, income and capital rights attaching to the growth shares, including any performance targets and leaver provisions.

If employees leave employment, they will normally be required to transfer their shares (e.g. to another shareholder or an employee benefit trust). The price leavers receive will normally depend on whether the employee is a good leaver or a bad leaver.

For smaller companies, even greater tax efficiency can be achieved by granting EMI options over growth or hurdle shares.

Entrepreneurs’ relief (reducing CGT to 10%) may be available for growth shares if the necessary conditions (particularly 5% of ordinary share capital and voting rights) are achieved, or where the growth shares are acquired through an EMI option.

The initial value of growth shares has to be very carefully considered. It is no longer possible to get informal HMRC approval of the share valuation following the issue of growth shares unless structured in conjunction with an EMI option. We have good relationships with professional valuers, whose advice at the structuring stage is invaluable in preparing for any possible dispute with HMRC about valuation in the future.

Growth shares can be enormously effective as an incentive and help to align the interests of key employees with those of the shareholders. They can be very tax efficient if designed properly. Companies need to ensure that their advisers can help on the tax, corporate and employment law issues as getting these matters right is essential to success.

Contact one of the Tax and Incentives Team with any questions, or to request further information and advice.