Optimising Employee Equity Incentives

Attracting and retaining key employees is an essential part of growing a successful business but this can often prove a challenging area for entrepreneurial companies. Using share based incentives to compliment a larger remuneration package allows the employees to share in the capital growth of the business by aligning their interests with the other business owner, be that focusing on the growth strategy or driving the company towards an exit.

A popular model for providing equity incentives are Enterprise Management Incentives (“EMI”), an HMRC approved, flexible share option plan aimed at helping smaller independent companies recruit and retain high calibre employees who are key to the future success of the company.  EMI is a method of rewarding key management for taking a risk by investing their time and skills to aid the company’s growth, while allowing them to participate in the growth which they have helped to generate.

An ‘exit only’ EMI can be adopted whereby the exercise of options is conditional only on a pre-determined exit event – i.e. the sale of company. This can be beneficial for companies as it allows for minority shareholders to be kept to a minimum and while the employees are option holders there is no requirement for them to be party to shareholder decisions.

There is no Income Tax or National Insurance on the grant or exercise of the EMI options assuming the exercise price is not less than market value at grant. A further benefit of an EMI is that Entrepreneurs’ Relief is available on the disposal of the option shares provided these were granted 24 months prior to a disposal. There is no 5% shareholding or voting requirement for shares acquired via an EMI.  Given the further complexities added to the qualifying conditions for Entrepreneurs’ Relief by Finance Act 2019, this is an ideal way of securing this relief where it is difficult to ascertain if the individuals would meet the new 5% economic tests.

However, due to their size or the activities undertaken, a company may not meet the conditions required to qualify for an EMI option plan.  Many of the other HMRC approved share plans that exist are generally for the benefit of all employees of the company and although useful, don’t provide the discretion to incentivise only key members of the management team that are crucial to the growth and success of the business.

Therefore, other tax advantaged incentives have become popular to assist these businesses achieve their desired level of growth and provide shareholder value. The good news is, alternatives do exist with an increased focus on the use of Growth Shares as an incentive.  Although not an HMRC approved plan, Growth Shares do provide a tax incentive with all growth in value from award being subject to Capital Gains Tax instead of Income Tax.   Generally, a Growth Share plan involves the creation of a new class of shares which do not participate in the existing value of the company, preserving this for the existing shareholders. The right to participate on an exit will be linked to the performance of the company and typically only kick in once certain pre-determined hurdles are achieved.

Due to the restrictions placed on the class of shares, Growth Shares typically have a low value when they are awarded, making these affordable with minimal Income Tax and National Insurance implications. Growth Shares are a specialised area and complex valuation methods are often necessary, consequently expert advice is essential.

If you require any help please do not hesitate to get in contact with Lynn Wilson, Corporate Tax Director, or your usual AAB contact.