Equity participation in the UK – different types of shares schemes
Working with a lot of founders as I do, you see a lot of similar areas of concern come up from time to time. One of the biggest areas of concern, and where founders often get it wrong, is when to give away equity in their business in the form of a share scheme.
A share scheme is a way of sharing company ownership with employees and is a powerful tool in talent acquisition and retention.
Offering a share award could make the difference in attracting the right people when money is tight, and the business can’t pay market rate salaries. There is often a period before staff can realise the value of shares, typically 3 years, which makes share schemes effective in retaining employees. Finally, they reward good performance and incentivise for the future through giving staff a direct stake in the business’s success, or ‘skin in the game’.
Things to consider
A business needs talent to grow but attracting talent of the right calibre is often difficult. This is especially the case when you are a boot-strapped, under-funded start-up that can’t afford to offer competitive salaries or even any salary at all! For many businesses, offering equity becomes the go-to option to help recruit, retain and incentivise good people. The problem is knowing when to do it and how to do it in the right way!
The when is down to each business and founder – however, the golden rule is to delay for as long as possible to ensure that you retain the controlling ownership of your business – after all, it’s your blood, sweat and tears that have built it! That said, you must be realistic about when you need additional resources to help you on your journey – that ‘goldy-locks’ moment of getting it ‘just right’ is really difficult to call…
The other aspect that founders struggle with is how much equity to give away – again this varies massively from business to business and founder to founder. The starting point must be the realisation that generally once it is gone it’s gone – it can be very difficult to claw back vested equity. This means the amount of equity allocated to others must be carefully managed. The flip side, however, is that the allocation of equity must be meaningful enough to achieve its goal – which is to recruit, retain and incentivise… what that looks like differs from founder to founder, employee to employee and business to business.
Types of share scheme
Once you have worked out how much you want to give away and to whom, the next decision is how best to do it.
In essence, there are three ways of providing shares to employees:
1. Share Award
The employee is gifted shares and receives them straight away with immediate access to all the benefits, including dividends (if they are to be paid out). The downside for the company is that if the employee leaves, the business must try to get the shares back or risk their share register becoming heavily populated with former employees who are no longer contributing! From the employee’s perspective, they will almost certainly receive an income tax charge on the value of the shares gifted, which never goes down well!
2. Share Purchase
This is a straightforward scheme where a price for the shares is agreed upon, and employees pay you and receive dividends and any other benefits in addition to enjoying any appreciation in share value. However, the company is exposed to the same issue as with a share award about controlling who the shareholders are. From the employee’s perspective, they would have to buy the shares and this can be an unattractive proposition if they don’t want to invest the capital or put it at risk.
3. Share Option
The employee has the right to buy the shares at a pre-determined price in the future. There is little risk for the employee, and you can claw back from leavers if the shares are not vested. Any tax liability is also deferred. If the price increases, the employee exercises the option to buy the shares at the agreed price – if it decreases, they don’t have to exercise the option.
You can make the shares available for any of the above either through issuing some of the company’s existing shares or issuing new shares, possibly as a different class and often attaching different rights.
The best option
There are four HMRC-approved schemes in existence Share Incentive Plan (SIP); Save As You Earn (SAYE); Enterprise Management Incentive (EMI) and Company Share Option Plan (CSOP). In reality, the EMI is likely to be the best way to go for an early-stage business due to the tax advantages available for both employer and employee.
Lots of people have heard of the term ‘EMI’ and there are lots of emails in people’s Inbox talking about allocating shares on this basis, but there are some quite strict rules that must be followed if using this type of scheme.
The benefits of going down an approved share option plan in the form of an EMI are primarily:
- There is no income tax charge or NIC charge at the date of grant and none on exercise where the exercise price is no lower than market value; (if the option is granted at a discount, then this will trigger an income tax and NIC charge)
- On disposal of the shares, the increase in value from the market value at the date of grant will usually be liable to CGT at the Entrepreneurs’ Relief 10% rate of tax. If the sale takes place within 24 months from the date of grant, the standard rate of 10% and/or 20% will apply depending on whether the individual is a standard or higher rate taxpayer.
Another attraction is the ability to agree on the market value of the company in advance and to apply to HMRC for ‘advance assurance’ that the scheme will qualify. To qualify the following conditions need to be met:
- The company must have gross assets of £30m or less, which is usually the case with an early-stage business.
- The company must have 250 or fewer employees – again usually not an issue with early-stage businesses.
- All employees must work at least 25 hours a week or 75% of their total working time for the company – this includes self-employed work.
- A maximum of £250,000 in share value can be granted to each individual over 3 years – this again is usually not an issue at the early stages.
- The limit on the total value of options for the company that can be granted is £3m.
- Employees who have a holding of 30% or more of the share capital before the options are granted do not qualify for EMI options.
- The options must be capable of being exercised within ten years of the grant.
- There are certain ‘disqualifying events’ that need to be looked out for, such as a change of control in the ownership of the company, the employee leaving before the options have been exercised, or the company failing to meet the trading activities test.
Most early stages companies should be able to meet all the criteria listed above. Setting up an EMI scheme is not hugely expensive, but every penny counts so we would recommend that early-stage companies don’t jump too soon! To the same degree, don’t give away lots of your equity upfront to individuals that may not be on the journey with you for the long term.
At arch.law we can help you choose the right form of equity participation for your business to ensure that you recruit, retain and incentivise those that are a good fit for your business and the right people to share your journey with you.
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