Preservation of cash whilst retaining key employees – welcome to the world of sharebased incentives.
Share-based incentives are not only a great way to incentivise key staff but to retain them as well. This is especially true for those businesses that can no longer offer cash rewards – whether attractive salaries
Share-based incentives have sometimes gone under the radar in smaller private businesses. However, there is a notable uptrend as businesses increasingly see them as an excellent incentive. From an employee perspective, sharebased incentives can be the carrot at the end of the stick helping maximise performance, focus minds and ensure employees feel they have skin in the game.
From the perspective of the employer, they reduce drain on cash which could be used on other critical projects, ensure retention and can sometimes be far more tax efficient than a traditional cash arrangement.
You might think that share-based incentives are complex to arrange and can leave businesses in difficulty if, for example, an employee leaves. But this does not have to be the case. Well drafted scheme documents can leave employers well protected and be structured much in the same way as a bonus arrangement to include targets which focus on financials, length of time or equity value. Importantly, well drafted documents should be easy to understand, making them an easy sell to the employee.
Most people will have heard of Enterprise Management Incentives Options (EMI options), and quite rightly so, as these are some of the most popular arrangements available.
Designed for traditional owner managed businesses, EMI options provide employers with a tax efficient way to incentivise key employee with shares. Whereas cash and some other share based arrangements would usually be taxed on an income basis, granting EMI options to an employee can, if structured correctly, allow a deferral of most tax until the sale of the option shares, and then on an efficient capital gains basis.
An employer will usually grant EMI options to be purchased at market value on the date of grant, a value which can be pre-approved with HM Revenue and Customs giving added certainty. Furthermore, as HM Revenue & Customs may accept that a small minority shareholding has a discounted value, the approved market value at the date of grant may be lower than you may think. On this basis, when the employee exercises the EMI option, they pay the discounted value (calculated at the date of grant) and could eventually pay capital gains taxes on the whole of the increase in value.
With tax to pay minimised, the employer (and ultimately the existing shareholders) can give less away to achieve the same post tax paid outcome. The difference is can be surprising.
There are some restrictions meaning that not every business will qualify, nor are EMI options available to certain employees or non-employed consultants. In these instances, businesses should think more inventively, or accept the risk that tax is likely to be paid on a higher basis.
An unapproved share option (which can be granted by companies to most employees and non-employed consultants) is seen as a tax inefficient arrangement as any gain until such time as the option was exercised could fall within the realms of income taxes. However, it may still be worth considering an unapproved share option if no other options are available.
From a commercial perspective, a key attraction of an option based share incentive is that they are just an option, and if the option is never exercised then the holder does not own shares.
Trigger events for exercise of the option are important, and many companies opt for an exit only option meaning that it can only be exercised as part of a sale of the whole. Clearly this may be inappropriate if the
business model is such that an exit isn’t going to be achieved in the near to medium term. In this instance, trigger events for exercise can be linked to time and/or performance criteria.
Options are also hugely flexible as they can be crafted to maximise the incentive whilst protecting the business against future events. However, it’s important to get the documentation right to avoid getting in a pickle. For example, if the option is to be exercised only on a sale of the whole then an employer needs to make sure the option holder is required to enter into the sale documentation. This means they can’t hold up or delay the sale. If the option holder can exercise earlier than on a sale, then you’d want to ensure the holder enters into a Shareholders Agreement with the other shareholders. Failing to properly consider crucial elements of the document can be catastrophic.
Whilst the holder of an option may have to pay something for the shares when they exercise the option, often a cashless exercise mechanism means that the holder can set off proceeds from the sale of shares against the exercise price – therefore they don’t need to raise any cash.
If EMI options aren’t available, then rather than grant unapproved options it may be preferable to grant actual shares, meaning any gain is taxed on a capital-gains basis as opposed to income tax. If the shares issued to the holder are done so at a discount to market value, then the discount could be within the income taxes regime. Whilst not preferable, thereafter any increase in value could be taxed on a capital-gains basis. Unlike EMI options, with unapproved options and growth shares it isn’t possible to seek approval of market value in advance, so there’s a risk that in future the value set as market value is disputed by HM Revenue & Customs, resulting in an unexpected tax liability.
Clearly it is not ideal for any tax to be payable on the issue of the shares in question. On that basis, anything that can be done to limit the day-one value (and thus any tax payable) is important. By allowing employees to share in the increase in value of the shares, growth shares can be used to limit the value given to the employee on day one.
If any tax was payable on day one, there is the possibility that a small cash-bonus arrangement could be used to pay it. Similarly, a bonus could be paid to the employee so that the shares can be issued at full value (which could be a lesser value if growth shares are used).
Issuing actual shares requires adequate shareholders’ agreements and articles of association, and employees should be involved in shareholder meetings and decision-making. As such, this option may not be for everyone.
Ultimately, the way businesses look at remuneration is changing, and share-based incentives are a big step forward, especially if those incentives are EMI options.