Practical guide: Using a growth share plan as an alternative to EMI options

Scenario

A company in the hotel trade has plans for a sale to a third party in five years’ time. The owner believes the sales manager will play an important role in achieving that sale and wants to ensure they remain with the company and is rewarded for the growth they produce. The company has a current value of £1 million and the owner would like to protect this value for themselves and offer the manager the opportunity to buy into 10% of the company.

The manager does not have sufficient funds available, so an outright purchase of the shares is not possible. Could a share option plan be the answer?

 

Share option plans

A share option plan does not involve the issue of shares to an employee, but rather the employee is granted the option to acquire shares at a future date. Often this is when the company is sold. These are referred to as “exit-only” options.

No payment is due from the employee when the options are granted, but instead payment is due when the options are exercised and the shares purchased.

In the case of exit-only options, the purchase and sale of the shares happen concurrently when the company is sold, meaning the sale proceeds are used to fund the purchase price. This is a huge advantage for the sales manager as they won’t have to outlay any cash until they receive the sale proceeds.

The purchase price is set at the market value of the shares at the date they are granted, therefore the employee receives the benefit of any growth in value of the company between grant and sale.

Example. Options over 10% of the shares in the client company are granted to the sales manager. Ignoring any discount for a minority shareholding, the market value of the shares, and therefore the purchase price, is £100,000.

If the company grows in value and is sold for £2.5 million, the manager will be due £250,000 in sales proceeds, of which £100,000 is used to purchase the shares. The difference of £150,000 is the manager’s gain on the shares and this reflects their share of the growth achieved.

A share option plan would therefore appear to offer an ideal solution as the shares would not need to be purchased until a sale of the company is achieved. But what are the tax consequences?

 

Tax advantaged?

The gain realised under a share option plan is taxed differently depending on whether it has tax advantaged status or not. There are four tax advantaged share schemes available, each with different conditions.

The share incentive plan and save as you earn scheme must be made available to all employees and are therefore not appropriate for the company in this hypothetical scenario.

The enterprise management incentive (EMI) and company share option plan (CSOP) are “selective employee” schemes so would be appropriate. However, a hotel trade is an excluded activity of the EMI, and the share limit for CSOP is only £60,000 (since April 2023 - £30,000 prior to that date). Therefore, neither scheme meets the company’s needs.

 

Non-tax advantaged share options

A non-tax advantaged share option plan has the benefit of having no constraints over qualifying activities, share limits, or participants and so could be a possibility for the company. However, to compensate for the flexibility, any gain made on the options are subject to income tax instead of capital gains tax (CGT).

Is there an alternative that would combine the flexibility of an unapproved share option plan with the tax benefits of an approved plan?

 

Growth shares

A growth share is a special class of share which seeks to incentivise the employee by allowing them to share in the future growth of the company. The shares are issued with particular rights which only allow them to share in the value once a certain threshold, or hurdle, is met. The shares are usually structured so that the current value of the company is protected for the existing shareholders, and the employee’s growth value is only realised when the company is sold. The value realised is then subject to CGT as a share disposal.

The shares are flexible as they can be issued in any company and there are no restrictions over the company activities, the number of shares issued, or who can be issued with shares.

Example. The company amends its articles of association and creates a new class of growth share that has no rights at all, other than to participate in the proceeds of sale pro rata with the ordinary shares, but only on a sale above £1 million. There are 90 ordinary £1 shares in issue belonging to the owner, and ten new £1 growth shares are issued to the sales manager who pays par value for the shares.

If the company is sold for £2.5 million, the first £1 million of proceeds will belong to the owner, with the sales manager being entitled to 10/100 (10%) of the remaining £1.5 million. The end result is that the manager is entitled to £150,000 which is the same as under an unapproved share option plan, but the gain is subject to CGT and not income tax.

 

Valuation

The fundamental characteristic and attractiveness of a growth share plan is that the value of the shares when issued is negligible so that the employee can afford to purchase the shares outright. The shares then flower in value once the hurdle is met.

The initial value is low because the shares have no rights to participate in the sale proceeds of the company until the hurdle is exceeded, meaning they will have little intrinsic value at the outset.

Example. Continuing the example above, if the company was sold for £1 million shortly after the growth shares were issued, the sales manager would be entitled to nothing. This together with the fact that the shares do not carry any voting or dividend rights would suggest the shares are virtually worthless.

 

Hope value

Ensuring that the shares do in fact have a negligible value can be a difficult task and will depend on how stretching the hurdle is likely to be to achieve.

If the hurdle is set at, or only marginally above, the current value of the company, HMRC will try to argue that the shares have a hope value greater than their intrinsic value, as the likelihood of the hurdle being met is probable. Any difference between the price paid by the employee and its determined value will be subject to income tax.

 

Restricted securities

Growth shares are employment-related securities which will most likely have restrictions attached, e.g. forfeit restrictions or restrictions on when and who the shares can be sold to. They will therefore be subject to the restricted securities regime where the difference between a growth share’s full (unrestricted) market value and its actual market value (when taking into account the restrictions over the shares) is subject to income tax whenever the shares sold.

Example. A growth share with no restrictions at all is valued at £1, but a growth share with restrictions is valued at 85p. On issue of the shares an employee will need to pay 85p per share on the actual value. The percentage difference of 15% will be subject to income tax on sale.

To ensure the value realised on the growth shares is taxed fully under CGT,  it is generally advisable for the company to enter into a joint election with the manager under s.431 Income Tax (Earnings and Pensions) Act 2003 within 14 days of the share issue. The manager will then be taxed on the initial unrestricted market value of £1 per share instead of 85p but would suffer no income tax on sale.