Growth Shares can be a useful solution for organisations that want to use equity to incentivize and retain important personnel when an EMI share option scheme is forbidden owing to regulatory limits. Employees in the UK who own growth shares can still benefit from large tax benefits.
What are Growth Shares?
Growth shares are a long-standing method for allowing employees to benefit from share ownership without incurring prohibitively high initial costs. As opposed to share options (other than EMI or CSOP), they allow employees to become shareholders immediately on conditions that can be modified by the firm to give an effective incentive to grow the company’s value.
The tax treatment is also far less expensive, which is crucial for private companies where the exercising of an option can result in the employee having to pay a considerable amount in tax but obtaining no cash out of which to pay it if there is no market for the shares received. As a result, the employee will face a “dry” tax charge with a real cash outflow, which is the primary issue that growth shares are frequently utilised to remedy.
Growth Share Characteristics
Growth shares are distinct from ordinary share capital and often do not entitle the holder to dividends or voting rights. The shares are frequently restricted to participation on an exit-only basis, such as when the firm is sold or an initial public offering is made.
Growth shares are subject to a ‘hurdle’ in order to encourage the company’s future growth. If a firm is currently worth £10 million, the shares could, for example, specify a threshold stating that holders of growth shares will only be entitled to a share of any exit proceeds exceeding £12 million.
Because there is a chance that the company will not achieve the requisite growth to benefit from the shares, the shares may have a lower market value when distributed to employees than ordinary shares. Employees can now invest in the firm at a lower cost.
Because growth shares only allow holders to share in the company’s future growth, there is no dilution for existing shareholders in terms of the company’s current “built-in value” at the time the shares are issued.
Growth shares can be utilised in combination with an Enterprise Management Incentive (EMI) plan, which is especially helpful when the company would struggle to make meaningful grants under the £250,000 individual limit due to the higher value of the ordinary shares. Unlike EMI options, they do not have a time limit and may be a good alternative for companies that do not anticipate exit in the near to medium term.
The shares can be subject to vesting and leaver provisions, making the arrangements commercially similar to a market value option arrangement.
The Taxation of Growth Shares in the UK
The tax treatment of a subscription for growth shares is best described by an example: suppose a firm is worth £10 million at the time of the issue of the growth shares, and an employee subscribes for shares that provide the employee 1% of the company value over a £12 million threshold. In this example, the shares are valued at £1,000 at the time of subscription, and the employee pays the full market value for the shares, resulting in no tax or National Insurance contributions (NICs) to pay at the time of issue. If the company is later sold for £20 million, the value of the shares will be £80,000 (1% of £20 million less £12 million). The employee’s gain of £79,000 – the £80,000 exit value less the £1,000 paid for the shares at the start – will be taxed as capital gains (CGT).
If instead of paying the £1,000 market value of the shares in the preceding example, the employee is issued the shares at a discount, the discounted element would be subject to income tax and possibly NICs at the date of issue of the growth shares, in addition to the CGT on disposal of the shares. Because the market value of a growth share cannot be agreed upon with HM Revenue & Customs (HMRC), it is critical that the firm undertakes a thorough assessment and keeps proper documents to substantiate the valuation if it is contested by HMRC in the future.
Read Also: UK TAX YEAR: All You Need to Know
Growth share plans can thus be a type of tax-efficient employee reward with low acquisition costs and CGT treatment on growth. However, this will only be the case if and only if the following conditions are met:
- There have been no modifications in tax legislation to apply income tax on the growth in value of growth shares; and
- CGT rates continue to be lower than income tax rates, particularly for higher-income individuals.
Employees should be informed of the possibility that the tax status of the shares would change after acquisition.
Benefits and Drawbacks of Establishing Growth Share Plan
Among the benefits are the following:
- Employees are given stock options at the start of their careers, and the acquisition expenses are typically minimal.
- There is no dilution for existing shareholders in relation to the current firm valuation, which could reassure current shareholders while also incentivizing key personnel to encourage the company’s growth; and
- Growth shares, unlike EMI options, do not expire after 10 years, thus they may benefit employees in companies that do not plan to exit in the short to medium term.
The following are some of the drawbacks:
- Employees will be required to pay for the growth shares at the time of award because shares are issued to them upfront. If the employee purchases the shares at a discount to market value, they must pay income tax and perhaps NICs on the amount of the discount.
- HMRC will not approve a valuation for growth shares unless they are used in combination with an EMI option plan, thus the company should do a strong valuation each time the shares are given. This increases the costs of running a growth share plan and raises uncertainty because there is no guarantee that HMRC will accept the share valuation obtained by the company; and
- To form a new class of shares, amendments to the company’s articles of incorporation will be required.
Putting Together a Growth Share Plan
Typically, the following procedures are done to establish a growth share plan:
- Draft modifications to the company’s articles to create a new class of shares – growth shares;
- Obtain shareholder approval to change the company’s articles of incorporation;
- Create a growth share plan;
- Obtain a valuation for the growth stock;
- Enter into an arrangement with the necessary personnel – a growth share subscription agreement; and
- Employees should be given growth shares.
Methods for Utilising Growth Shares In UK
There are numerous sorts of growth shares. The following are examples of common categories of ideas:
#1. Traditional Growth Shares
Traditional growth shares entitle the shareholder to just the growth in the company’s value above a “threshold” or “hurdle” that is defined at the time of issue. Due to the fact that the company has not achieved growth, the shares are likely to have only nominal worth. However, HMRC frequently believes that the shares have a “hope” value in addition to the “intrinsic” worth of the share.
#2. Future Hurdle
Future hurdle shares allow the growth shareholder to profit solely from growth in the company’s value above a future hurdle amount, which is normally more than the company’s current worth at the time of share award. The impediment can be a number of objectives that the company must fulfil in its approach to an exit. It is not uncommon for blossoming shares and hurdle shares to be mixed.
#3. Flowering Growth Shares
Growth shares designated as blossoming shares become valued only if and when the company meets certain performance criteria. The performance criteria are typically linked to capital growth business objectives, such as:
- Goals for turnover;
- The sale of a company for a price more than a predetermined threshold.
#4. Waterfall Growth Shares
Growth shares designed to function as waterfall shares allow a shareholder to share in the company’s worth after certain other shareholders have been paid off. Waterfall shares are concerned with the distribution of profits after an exit. They function similarly to a set of buckets; when one is full, the other fills up. The benefit is that the earlier the other shareholders are paid off, the greater the payout to the waterfall shareholder. Waterfall shares are frequently employed as top-slicing inducements.
#5. Performance Ratchets
Growth shares with a ratchet give existing owners to increased entitlement to shares if the company meets certain performance criteria.
What are the Eligibility Requirements and Limits for Growth Shares in the UK?
For the company or beneficiary
- The shares are not subject to any restrictions.
In terms of the shares
- The shares are a new and distinct type of share.
- They can vote or not vote.
Is a Valuation Required to Issue Growth Shares In UK?
Yes, all growth shares have a hurdle rate. This is usually a minor premium above the company’s current worth. This sum, unlike EMI, cannot be pre-approved by HMRC. However, a valuation (conducted with the assistance of Vestd or your accountant) will usually provide a high level of comfort. Depending on the nature of the firm, a premium of 10-40% may be given to the market value to reflect any “hope value” of the shares, further mitigating any danger of HMRC concluding at some point in the future that these shares were undervalued at the time of issue. In the worst-case scenario, if they wanted to do so, they would impose income tax on any difference between the hurdle and the market price at the time.
Conclusion
Growth share arrangements can be simple and are an appealing alternative to non-tax-advantaged share options or if ordinary shares in the firm have a high market value and the employee is reluctant or unable to pay the full market value on acquisition. Companies in the UK who are unable to offer qualifying EMI choices or are having difficulty staying within individual EMI restrictions can explore introducing growth shares to incentivize staff.
Growth Shares FAQs
Are growth shares ordinary shares?
They are ordinary shares in a company’s capital with rights limited so that, in the case of a sale (or other realisation events), the holder will only receive a share of the company’s value over a certain threshold.
Can Growth shares pay dividends?
The growth share has no dividend rights and only receives a capital payout if the company is sold within a certain time frame.
Are growth shares subject to capital gains tax?
Employee dividends from growth shares are liable to capital gains tax (CGT).
What is a high growth stock?
Growth stocks are those that have a significantly higher growth rate than the market’s average growth rate. It indicates that a growth stock grows faster than the average stock in the market and, as a result, creates earnings faster.
