Over the years the UK has seen a variety of tax efficient schemes available to incentivize management; and in 2014 the Employee Shareholder Status (ESS) regime was added into the mix.
ESS essentially allows an employee to relinquish certain statutory employment rights in exchange for shares in the company, with any future gains from those shares exempted from capital gains tax (CGT). The CGT exemption applies to the first £50,000 worth of shares acquired (valued at the date of allocation).
While the ESS system has relevance to the PE sector, in reality it has struggled to gain a foothold, for a number of reasons:
- Reputation - ESS generated some negative publicity when it was first introduced and thus never really gained traction
- Certainty - management’s advisers often do not ask for ESS to be included in the structuring, preferring the greater certainty around Entrepreneurs Relief. ESS may be abolished depending on the outcome of the UK general election this year
- Uncertainty if the group is restructured - if the group is restructured, for example pre-IPO or sale, then the tax benefits of ESS may be lost
- Complexity - implementing such a scheme can negatively impact the timing and/or process of a deal, particularly if the deal is a competitive auction
- Lack of monetary consideration - the employee shares are acquired in consideration for the surrender of employment rights. To be true incentives, some PE funds prefer mangers to invest real money into the investee company
Entrepreneurs’ Relief (ER) is a more established scheme and is widely thought to provide more certainty than the ESS regime. The former is simpler and more tried and tested. It applies to an employee or officer that owns at least 5% of the nominal and voting share capital in the employing group, and allows them to sell the business at a reduced tax rate of 10% (compared with the typical rate of 28%) on gains up to £10 million.
Growth shares are another more certain option when trying to make available equity to a broader management team. This special class of shares allows individuals to make a small upfront investment and realize capital gains if the company performs well. It is an affordable way of attracting management and employees into a share incentive scheme and into the CGT system rather than income tax. Ordinarily, when a PE sponsor invests in a company, the share value naturally increases and the new management team finds the equity too expensive. Growth shares are an attractive way of overcoming this hurdle.
Aligning the interests of the management team with the sponsor is always one of the primary objectives of a fruitful PE investment, and while the ESS regime may not be appropriate in many instances, ER and growth shares provide a more certain option to facilitate management’s tax efficient investment.
The general election in May could decide the future of the ESS system and even if it remains, it is likely the scheme will apply more to smaller deals and proprietary early stage investments. We believe that more established schemes such as Entrepreneurs’ Relief and growth shares are likely to remain more compelling to the PE community.