Since September 2013, companies have had the opportunity to enter into employee shareholder agreements with their employees, under which employees give up certain statutory employment rights in exchange for acquiring shares worth between £2,000 and £50,000 in their employing company (or the parent of their employer) with certain tax advantages, including an exemption for capital gains tax. Now, over 18 months since the implementation of the employee shareholder regime, we take a look at how frequently it is used in the private equity industry, what the key practical challenges are and what the future holds.

How much are we seeing the regime used in the private equity industry?

Despite the overwhelming initial response being either negative or mixed, we have seen the use of employee shareholder shares become increasingly popular in the private equity industry as a way of incentivising key players in portfolio companies.

For many companies and their employees, the benefit of acquiring equity and the potential  tax advantages simply do not outweigh the disadvantages of losing employment rights and the potentially high costs of implementation. However, for private equity houses wishing to incentivise senior employees, the balance does tend to swing the other way and the industry is becoming increasingly aware of what place the regime has for its senior management teams.

What are the key challenges?

Prior to the introduction of the regime, we anticipated that whilst in principle the proposals seemed relatively straightforward, the implementation process was likely to be complex with companies having to follow a prescribed procedure and ensure numerous pre-requisites are in place. Having implemented a number of these schemes, we now have a clearer idea of the challenges and how best to tackle them.

Timing and logistics

This is the single most notable challenge in implementing the employee shareholder regime, simply because of the timing constraints which companies will not be familiar with on a typical issue of shares for cash consideration. HMRC has very helpfully set up a facility for agreeing the market value of employee shareholder shares which gives the parties involved the certainty they need. However, from the date of the valuation the clock starts ticking and the company then has 60 days within which  to complete the issue. Whilst this may appear ample time, in practice, when co-ordinating a potentially large number of proposed employee shareholders, the negotiation of documentation with the independent adviser and ensuring that at least seven clear days are left between the individual receiving their independent advice and entering into their employee shareholder agreement, time can often be tight and it is worth having a clear timeline in place at the outset.

It is also common that proposed employee shareholders may be asked to take “skin in the game” via a separate investment into the group, for example through subscription for other shares or loan notes, immediately prior to the employee shareholder issue. In particular, for those who are not existing shareholders, a redeemable share or similar will need to be subscribed for in cash in order to ensure the individual is eligible to become an employee shareholder should they choose to do so. This inevitably puts further pressure on timing and logistics.

No consideration

In order for employee shareholder shares to qualify as such, no consideration should be given for the shares other than the entry into the employee shareholder agreement and the giving up of statutory employment rights. The issue here is that the legislation is still relatively new and untested and there is limited guidance from BIS on what may constitute consideration for these purposes.

It is often appropriate for an employee who is taking equity in its employing group to enter into new employment terms (for example more robust restrictive covenants). We have therefore had to consider whether this could be construed as “consideration”. Where companies are recruiting new employees as employee shareholders they can require that those new joiners accept employee shareholder status as  a condition of employment. On that basis, and given that it would be hard to construe entry into a new service agreement as direct cash consideration, this should not be regarded as consideration. Where there is a decrease in salary the position may be different as this is more easily comparable to “cash”, although this is still a broad interpretation of the legislation and should not invalidate the employee shareholder status.

As mentioned above, proposed employee shareholders may be asked to invest in the group in other ways at the same time as being offered employee shareholder shares. The general consensus seems to be that provided this investment is clearly separated from the employee shareholder issue (e.g. individuals  are not offered a certain class of share for a mixture of cash consideration and as employee shareholder shares (which could result in the cash consideration being construed as “consideration” for all the shares)) and provided the documentation is kept distinct in order to represent a clear separation between the investment (e.g. in loan notes) and the offer of employee shareholder shares, this should not be regarded as “consideration” under the legislation.

Amendments to articles of association and investment agreement

Companies often need to amend their existing articles of association and investment agreement in order to, amongst other things, introduce a new class of shares (such as a class of redeemable shares for those who are not existing shareholders), give the company the power to capitalise reserves and appropriate such sums by way of a bonus issue on a non-pro rata basis (the most common way we have seen for funding employee shareholder issues so far) and increasing the company’s authority to allot. This  is relatively straightforward to achieve but is another step to factor into the process and will require various shareholder and investor consents are obtained in advance. It is also important to ensure that there are sufficient funds in the company’s share premium account and if not, how these might be increased prior to the issue or alternatively which other methods may be used to fund the subscription.

Issue of new shares

In response to queries surrounding the requirement that only new shares could be issued as employee shareholder shares, BIS suggested earlier this year that existing shares could be used and that the words “issue or allot” can include a transfer. Our view is that given the legislation clearly refers to “allotment or issue” and not to a “transfer” we cannot see how the courts could interpret the legislation in this way. We have therefore continued to advise clients to issue new shares to proposed employee shareholders and to not rely on the transfer of existing shares.

What does the future hold?

It looked as though a Labour majority or a Labour and Liberal Democrat coalition might put the employee shareholder status at risk. However, with the Conservative government retaining control for another term it appears that the regime may be safe for now.

HMRC and BIS have both demonstrated their commitment to the regime by issuing extensive guidance and confirming that they do not anticipate challenging an individual’s employee shareholder status, even in cases where statutory employment rights foregone have been reinstated in employment contracts.

Employee shareholder status already had its advantages over entrepreneurs’ relief, namely that the various conditions required for entrepreneurs’ relief do not need to be met for employee shareholders and that the regime gives a nil rate of capital gains tax on any gain made on a disposal of the first £50,000 worth of shares (as valued on the date of acquisition) in contrast to the 10% rate under entrepreneurs’ relief. It now has a further significant advantage following the changes to entrepreneurs’ relief announced  in March of this year which mean “manco” structures can no longer be used to try to obtain entrepreneurs’ relief (see our breaking news alert on this here). We predict these changes will only serve to make the employee shareholder status even more attractive to the private equity industry which has, up until recently, relied heavily on the use of “manco” structures in order to give senior employees access to entrepreneurs’ relief.

As a result, we expect to see many more employee shareholder arrangements over the next year, particularly now that private equity houses and management teams, together with their advisers, are becoming increasingly familiar with the most efficient and effective way of implementing these.