Private Company Employee Equity Incentives

Mishcon de Reya

It is well established that publicly listed companies have a variety of arrangements in place to enable their employees to buy or receive shares in the company. This may range from plans that entitle senior management to receive free shares at the end of a defined period if certain performance conditions are met, to plans designed to enable all employees throughout the organisation to become a stakeholder in the company, often through tax advantaged arrangements.

For privately owned companies however, there is often an assumption that it is not possible, or at least it is practically much harder, to facilitate a similar share ownership culture. Of course one of the main reasons for this is that there is generally no market in private company shares and therefore there would seem to be little or no opportunity for employees to realise value from being a shareholder.
Whilst it is true that private company shares cannot be traded in the same way as those of a publicly listed company, there are alternative ways in which value can be delivered to employees in a practical and cost effective manner. Indeed the market has seen significant growth in employee share ownership in private companies in recent times due to both new legislation having been introduced in the UK encouraging such arrangements and there being greater publicity around certain ownership models, such as that adopted by the John Lewis Partnership.
What are the commercial objectives?
The first questions that companies (whether listed or private) need to carefully consider are why employee share ownership might be appropriate for them and what the objectives of any such arrangement should be. Being clear on the answers to these questions will guide them on what structure(s) would be most suitable and in particular whether the incentive should provide a direct share ownership, an indirect share ownership (typically through a trust arrangement), or a hybrid of the two.

Some guiding principles are as follows:

  • does the company want to provide a strong link between company performance and employee reward
  • does the company need to attract new and/or retain existing high performing individuals?
  • does the company want employees to identify as joint owners of the business and to focus on its long-term interests?
  • is the company concerned about paying employees in a tax efficient way and/or trying to conserve cash?
  • does the company want employees to benefit only on an exit (i.e. a public listing or trade sale)?
  • does the company need to manage succession planning and is the intention for the company to become employee controlled rather than have third party investment?
  • does the company want to protect itself from a takeover?

Exit only arrangement?

Underpinning any specific structure, it will usually be appropriate to first decide whether employees should be able to realise value only on there being an exit event, or to provide for specific/regular vesting opportunities.
The answer to this will largely depend on the company’s profile. For many companies, the founder shareholders or a private equity investor will be looking to sell or list the company in the medium term and will want to gear any share arrangements around such an event taking place. They will therefore want employees to be “locked in” until and to only participate in any value creation at that time.
On the other hand, a company whose objective is focussed more on collective ownership is unlikely to link a vesting with an exit but rather will want to allow employee shareholders the facility to crystallise value on a more regular basis. The company will therefore need to consider how it could create an internal market in its shares. Some options might be to:

  • set up an employee benefit trust which purchases the shares. For this purpose, the trust will usually be funded by the company. Those shares can then be re-used for new joiners/new awards. A professional trustee will often be engaged for these purposes; or
  • the company buys back the shares either into treasury or for cancellation. There are various company law requirements that need to considered in this respect.

So what structures are available?

Direct share ownership

Where a company determines that direct share ownership is appropriate, it will then need to consider how to deliver shares to its employees. Broadly it could do this by either:

  • granting options/awards, which give employees the right to acquire shares in the future; or
  •  implementing a share purchase arrangement, where the employee acquires an immediate interest in the shares.

There are a variety of plans that can accommodate these structures:

mishcon-private-company-esop-csop

These plans are summarised in the table at the end of this page – click here

Indirect Ownership

Where indirect ownership is considered appropriate, this will usually be structured through a form of employee benefit trust. Here, shares will be delivered to the trust which will hold them on behalf of employees. The trust will need to operate the trust and make decisions on how to distribute or manage the shares in the best interest of the employees.

This model is relatively straight forward to operate and may be appropriate in circumstances intended to create longer term benefit to employees and/or to create a more employee controlled culture.

A new form of employee trust is available which provides tax reliefs where the trust holds a controlling interest in the company (broadly more than 50% of the share capital of the company). Where certain other statutory requirements are satisfied:

  • there will be capital gains tax relief on the sale of shares into the trust
  • the company will be able to make bonus payments of up to £3,600 to each employee in each tax year, free of income tax (NICs is still payable however) and
  • certain inheritance tax reliefs are available on transfers into and from the trust.

Conclusion

There are many considerations that need to be taken into account when designing and implementing an appropriate incentive arrangement. Ultimately, to ensure the chosen structure is successful for the business requires the overall commercial objectives to be well thought through and agreed at an early stage.

purple2 Company Share Option Plan ( CSOP )

How does it work?

All employees invited?

Are there any limits?

How are they taxed?

This is an arrangement under which an employee is given an option to buy a specified number of the company’s shares in the future (which could be subject to certain performance conditions being met).

On exercise, for each share, the employee pays the price that is equal to the market value of a share at the date of grant.

Options can be exercised during an exercise period (which will usually start on the third and end on the tenth anniversary of the date of grant)

No. This is a discretionary arrangement and the company can choose which employees to grant options to (subject to certain statutory conditions). If taxed-advantaged options are granted (see next box), an optionholder can only hold unexercised options over a total number of shares worth no more than £30,000 (valued at the date of grant).Tax-advantaged options can be granted alongside a non tax-advantaged option where it is necessary to grant in excess of the limit.

Yes. A company can only grant EMI options if it has gross assets of no more than £30 million and fewer than 250 full-time employees.
There is also an overall limit of £3 million worth of shares that can be subject to all unexercised options granted by the company (valued at the date of grant).
In addition, an optionholder can only hold unexercised options over a total number of shares worth no more than £250,000 (valued at the date of grant).
Are there any limits?

If certain statutory conditions are satisfied a CSOP option can be structured to benefit from tax-advantageous treatment.
When these options are exercised on or after the third anniversary of grant (but no later than the tenth anniversary), there will be no charge to income tax or NICs.
On the other hand, on the exercise of a non tax-advantaged option, income tax will be charged on the increase in value above the exercise price. National insurance contributions (NICs) will generally be charged on the same basis if the shares are readily convertible assets (i.e. broadly there are arrangements in place which enable them to be sold). Income tax is charged at the optionholder’s marginal tax rate.
On the sale of shares, capital gains tax may be payable on any gain which is over the tax-free limit (£11,100 for 2015/16). In addition, entrepreneurs’ relief may be available

 

 

purple2 Enterprise Management Incentive ( EMI )

How does it work?

All employees invited?

Are there any limits?

How are they taxed?

An EMI is another option plan but targeted specifically at small, higher-risk trading companies. They are therefore popular with private and AIM listed companies. Certain statutory conditions must be met, including those relating to the type of business being operated.
The exercise price can be set at less than the market value of a share at the date of grant, although there will be tax consequences of doing this.
There are no requirements on when options can be exercised, other than they must be capable of exercise within 10 years of grant. Because of this flexibility, EMI options are often granted in conjunction with both exit-only and performance related arrangements.

No. This is a discretionary arrangement and the company can choose which employees to grant options to (subject to certain statutory conditions).

Yes. A company can only grant EMI options if it has gross assets of no more than £30 million and fewer than 250 full-time employees.
There is also an overall limit of £3 million worth of shares that can be subject to all unexercised options granted by the company (valued at the date of grant).
In addition, an optionholder can only hold unexercised options over a total number of shares worth no more than £250,000 (valued at the date of grant).

On exercise, if the exercise price is equal to the market value of a share at the date of grant, there will be no income tax or NICs.
However, if the exercise price is less than the market value at the date of grant, income tax and NICs will be charged on the discount only.
On the sale of shares, capital gains tax may be payable on any gain which is over the tax-free limit. Entrepreneurs’ relief is also available.
There is more complicated tax treatment where there is a disqualifying event (such as ceasing to meet the trading activities requirement or on certain types of corporate events). Specific advice should be taken in these circumstances.

 

purple2 Save As You Earn ( SAYE )

How does it work?

All employees invited?

Are there any limits?

How are they taxed?

This is another tax-advantaged arrangement which must meet certain statutory conditions.
An SAYE plan consists of two elements. A savings contract and a share option. Under the savings contract, an employee agrees to save a set amount (deducted from post-tax salary) each month for either a three or five year period (as determined by the company). This amount cannot be changed once the contract starts (although it is possible to take a payment holiday of up to six months). The savings contract is entered into with an authorised savings carrier and the plan will usually be administered by a third party administrator.
In conjunction with the savings contract, employees are also granted an option to buy shares. The number of shares that can be bought will be set by reference to the total savings made at the end of the savings period, together with a bonus and interest (set at statutory rates from time to time).
The exercise price of an option can be set at a discount of up to 20% of the market value of a share at the date of invitation.
At the end of the savings contract, the optionholder can exercise the option (using the savings made) but does not have to. As such an SAYE option is risk free because if the value of a share at the time of exercise is less than the exercise price, the optionholder can simply take back the savings made. If the optionholder decides to exercise, he must do so within 6 months of the savings contract maturing.
Options cannot be exercised before the maturity of the savings contract, other than in certain good leaver circumstances or company events. However, in these cases, an option can only be exercised to the extent of the savings made at that time.

Yes. All eligible employees (as defined by the legislation) must be invited.

The minimum monthly saving that a participant can make is £5 and the maximum is £500

There will be no charge to income tax on the exercise of an SAYE option if it is exercised more than three years after the date of grant.
There will be no income tax charge if options are exercised earlier than three years from grant for certain “good leaver” reasons or company events (as defined by the legislation).
NICs are never chargeable on SAYE options.
On the sale of shares, capital gains tax may be payable on any gain which is over the tax-free limit. Entrepreneurs’ relief may also be available.

 

purple2 Long Term Incentive Plan ( LTIP )

How does it work?

All employees invited?

Are there any limits?

How are they taxed?

 

An LTIP is more commonly operated by listed companies, although may be appropriate for some private companies.
Under an LTIP, shares are acquired for free subject to meeting certain performance conditions over a performance period. A typical period will be three years.
Performance conditions often relate to a combination of business and individual targets.
LTIP awards are generally structured as either nil-cost options or conditional awards. Nil-cost options allow the participant flexibility of when to exercise the option, and therefore when to crystallise the tax charge. A conditional award will vest and pay out automatically at the end of the performance period.
LTIP awards can be (but are less commonly) structured as restricted shares which are acquired immediately by the participant but will have to be forfeited if the performance conditions are not met. The main commercial objective of using restricted shares is to allow the participant to receive dividends during the performance period.

No. This is a discretionary arrangement and the company can choose which employees to grant options to

No statutory limits although the company may be subject to internal limits under its articles of association or shareholders agreement.

On the exercise of an option/vesting of an award, income tax will be charged on the value of the shares acquired. If the shares are readily convertible assets, NICs will also be chargeable.
On the sale of shares, capital gains tax may be payable on any gain which is over the tax-free limit. Entrepreneurs’ relief may also be available.

 

– Options/awards

Share Purchase

purple2 Growth Shares

How does it work?

All employees invited?

Are there any limits?

How are they taxed?

 

Growth shares involve setting up a special class of share. This type of arrangement is therefore not often suitable for listed companies.
A growth share arrangement entitles the holder of the shares to participate only in the growth in value of the company above a certain threshold, the value up to that level being for the benefit of other shareholders.
Since growth shares are only able to participate in future growth and because they will be subject to good/bad leaver provisions (which may require the growth shares to be sold), the market value of the shares will typically be low or a nominal amount. This should generally make the growth shares affordable for those acquiring them. Agreeing a valuation of the growth shares with HMRC will normally be appropriate.
This type of arrangement may be appropriate to incentivise management where there is inward investment from a private equity firm and also for new management coming into the company to provide an appropriate incentive to increase value from that point on.

No

None other than those set on a commercial basis.

Provided the price paid for the growth shares is no less than their unrestricted market value when acquired, there will be no tax charge on acquisition.
When the shares are sold, the proceeds of sale will be subject to the capital gains tax regime.

 

purple2 Joint Share Ownership Plan (JSOP)

How does it work?

All employees invited?

Are there any limits?

How are they taxed?

 

A JSOP is a variation on the growth share structure, but does not require a new class of share to be created. Listed companies (particularly those listed on AIM) will therefore find a JSOP easier to operate.
Under a JSOP, the beneficial ownership of a share is split between the participant and a trustee. The participant acquires an interest in the shares which gives him the right to all the future growth in their value with the trustee’s interest fixed at the value of the shares at the time the award is made. The value of the participant’s interest should be low or nominal, but as with growth shares, agreeing a valuation of the JSOP shares with HMRC will normally be appropriate.
When the shares are sold on a trigger event (for example on an exit), the proceeds of sale are divided in accordance with a joint ownership agreement

No

None other than those set on a commercial basis

Provided the price paid by the participant for his interest in the shares is no less than its unrestricted market value when acquired, the participant will not be subject to a tax charge on acquisition.
When the shares are sold, the participant’s proceeds of sale (i.e. the growth in value) will be subject to the capital gains tax regime.

 

purple2 Share Incentive Plan ( SIP )

How does it work?

All employees invited?

Are there any limits?

How are they taxed?

A Share Incentive Plan is an all-employee arrangement which has tax benefits associated with it, provided certain statutory provisions are met. There are four elements of a SIP that the company can operate (it does not need to offer all of them):

  • free shares, under which employees can be given shares for no payment. The basis on which shares are given out must be the same for all employees. Free shares must be held for a 3 to 5 year period (as specified by the company) other than in certain leaver reasons or corporate events
  • partnership shares, under which employees can buy shares (either on a monthly basis or some other basis as set by the company) out of pre-tax salary
  • matching shares can be given for free to employees who buy partnership shares. Matching shares must also be held for a 3 to 5 year period, other than in certain leaver reasons or corporate events
  • dividend shares under which dividends paid on any of the employee’s free, partnership or matching shares, can be reinvested to buy more shares to be held in the SIP.

A specific UK based trust must be established which holds the shares on behalf of the participants.

Yes. All eligible employees (as defined by the legislation) must be invited

Yes, as follows:

  • Free shares – Up to £3,600 worth of shares can be given to employee in any one year
  • Partnership shares – Up to £1,800 worth of shares (or 10% of pay, if lower) can be bought in any one year
  • Matching shares – up to a limit of two matching shares for every one partnership share bought
  • Dividend shares – no limit

SIP shares can be removed from the plan free of income tax if they are held in the plan for at least five years. If they are removed between three and five years, there is an income tax charge, although this will be by reference to the lower of the value of the shares at that time and when they were originally acquired. For shares removed before three years, income tax will be due on the value of the shares on the date they are removed. There is no income tax charge in the case of certain good leaver reasons (as set out in the legislation).
Shares can be sold free of any capital gains tax if they are sold directly out of the plan.

 

purple2 Employee Shareholder Status (ESS)

How does it work?

All employees invited?

Are there any limits?

How are they taxed?

ESS was introduced in 2013 under which employees can be given at least £2,000 worth of shares in the company. In return the employee gives up certain statutory employment rights, including the right to bring a claim for unfair dismissal and the right to a statutory redundancy payment.
Achieving employee shareholder status entitles the employee to certain tax benefits and has become increasingly popular with privately owned companies and in the private equity context.
In order to achieve employee shareholder status, certain statutory provisions must be met

No

At least £2,000 worth of shares must be given to an employee

For tax purposes, a participant is deemed to pay £2,000 for the employee shareholder shares. Therefore, on acquisition, there will be an income tax charge on the difference between the actual market value of the shares received and £2,000. Generally to avoid any future income tax charges, it will be necessary for a S.431 election to be entered into.
On sale of the shares, there will be no capital gains charge provided that the value of the shares at the time they are acquired does not exceed £50,000. Any shares in excess of that amount will be subject to the capital gains tax regime.

Stephen-Diosi

Stephen Diosi Legal Director Mishcon de Reya Stephen.Diosi@mishcon.com

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