An aim of many owner-managed businesses is to realise the value in their business by way of an ‘Exit’, for example, a future sale or IPO.
However, to achieve that aim they are often reliant on the support of key employees (existing and future) who have nothing to gain from the process. Mechanisms such as bonuses or share options are hampered by tax considerations, formality and employees placing little value on them until the point they flower.
Growth shares may be a solution in aligning the exit horizon with the key task of attracting, incentivising, and rewarding key employees to get there.
What are Growth Shares?
As the name implies, Growth Shares allow key employees to share in future growth of the business. The present-day value is locked in for the current owners and the employee participates in any increase in value achieved from that point to exit.
What types of businesses typically use Growth Shares?
Growth Shares are typically used by non-listed businesses looking to eventually exit. Especially businesses where recruiting and retaining staff may be difficult and/or in sectors where established competitors may be able to offer more attractive salaries or pathways.
Whereas owners will typically hold ordinary shares, Growth Shares are aimed only at conferring a financial benefit for increased value over the present-day value.
Therefore, in most cases:
- they carry no right to vote
- they carry no right to dividends
- they are not transferable
- they are ‘forfeited’ if the employee leaves
So, what do they do?
The present-day value of the business is assessed. This is called the ‘hurdle’. The hurdle is for the benefit of the present-day owners who have got the business to that stage. The Growth Shares participate in value over and above the hurdle.
As an example, if a business is worth £5 million today and £10 million at Exit then the first £5 million goes to the present-day owners and the second £5 million is shared between the present-day owners and the Growth Share owners.
How do employees receive Growth Shares?
Typically, the employee buys the Growth Shares using personal funds or even a loan from the business. As Growth Shares have no guarantee of value as the hurdle may not be exceeded and do not have normal ordinary share rights (voting, dividends, transferability etc.) their market value is normally low.
How are these types of shares taxed?
There are 2 common circumstances in which tax should be considered: on acquisition and on sale.
As stated above the market value of a Growth Share is normally much lower than the equivalent ordinary share. Therefore, if the employee pays market value there is no tax impact. If the employee pays less than market value then, as with any benefit, the value of the benefit is subject to income tax and potentially NICs.
Let’s use the numbers from the example above (and let’s assume the employee pays market value for the Growth Shares):
- present day value of the business = £5 million (the hurdle)
- the Growth Shares have a market value of £500 and have a benefit to 5% of proceeds above the hurdle
- the employee pays £500 for the Growth Shares
- the business is sold at exit for £10 million
- the first £5 million goes to the present-day owners
- the second £5 million goes to the present-day owners (95%) and the employee (5%) being £4,750,000 and £250,000 respectively
- the employee will pay CGT on the gain i.e. £250,000 – £500 = £249,500 taxable gain
It should be noted that:
- as with any tax rules, they may change
- it is not possible to pre-agree the market value of Growth Shares with HMRC so we would advise a robust valuation is obtained
Can I combine Growth Shares with an EMI Plan?
In a word, yes. Moreover, this can have three additional benefits:
- Growth Shares do not need to be sold within 10 years whereas EMI options must be exercised within 10 years. This allows a longer window for exit.
- Growth Shares are not subject to the same £250,000 individual limit as with an EMI option.
- Any specific provisions in an EMI plan on vesting, leaving etc. can be replicated in the Growth Shares.
What do I need to do to put in place a Growth Share plan?
- Obtain a robust valuation. This can be through your financial advisors
- Speak to your legal advisor about:
- putting in place a Growth Share plan
- understanding what changes to your Articles of Association are required
- assessing how the plan will interact with your other current and planned incentive plans (such as EMI plans)
- how to discuss the plan with your relevant employees
Growth Share plans are straightforward and align the interests of owners with an exit on the horizon with key employees who will help get them there.
For advice on this or any aspect of business law, please contact our corporate and commercial law team by emailing firstname.lastname@example.org or phoning our Stoke-on-Trent solicitors on 01782 205000, our Altrincham solicitors on 0161 929 8446 or our Birmingham solicitors on 0121 516 3025.