Many family businesses struggle with the issue of whether and how to incentivise employees and particularly whether key staff should be given a share of the business. There are understandable reasons for caution, the most obvious being the desire to keep ownership and control within the family. The good news is that giving employees options or shares need not lead to loss of control. Moreover, two recent changes mean that shares and options given to employees now benefit from significantly improved tax treatment.
No loss of control
Concerns about loss of control are the main reason why family businesses balk at the idea of giving shares or share options to key employees. However, what many do not appreciate is that shares and options are very flexible and most concerns can be addressed by the way the share rights are drafted. For example:
- “Issuing shares could mean that we lose control over decision-making”. Normally this is not a concern because the number of shares which are issued to employees cannot materially affect voting. However, it is also common to ensure that employee incentives comprise non-voting shares, which benefit from the company’s economic success but have no effect on decision-making. If a choice is made to issue options (as opposed to shares), the concerns about control are further removed, because an option holder doesn’t actually become a shareholder (and therefore has no shareholder rights) until he or she exercises the option (which may only be at the point of leaving the company).
- “If we issue shares or options and employees leave we will have shareholders who have no connection to the business”. It is normal to ensure that when an employee leaves they must sell their shares, either to the other shareholders, to the company, or possibly to an employee benefit trust (which can reissue the shares to current employees who need to be incentivised). Provided that the employee is not leaving in acrimonious circumstances, the departing employee would receive a payment for the shares, which would reward them for their work. Options and shares can therefore provide a suitable incentive even where there is no intention to sell the company because the employee will sell the shares when they leave the company and realise value at that stage.
- “If we issue shares and buy them back when the employee leaves, we would have to pay an amount which reflects value created before the employee joined the company”. This need not be the case because shares can be given rights to participate only in value created after the date of issue - ie the employee benefits only from the value they have helped to create.
- “If we issue shares the employee could transfer them to someone else”. It is important that shares and options issued to employees are non-transferable (or at least must be offered back to the majority shareholders first), so that share ownership cannot spread in this way.
- “If we issue shares and, later, decide that we want to sell the company, we would be at the mercy of minority shareholders deciding whether they, too, want to sell”. It is normal to put provisions in a company’s articles to ensure that the decision to sell belongs entirely to the majority shareholders and that they can, if necessary, force minority shareholders to sell at the same time.
“Shares and options are more flexible than most people realise and recent changes have led to better tax treatment.”
Improved tax treatment
EMI share options: option holders can now receive entrepreneurs’ relief
Enterprise Management Incentives (EMIs) are tax-advantaged share options which are designed to help small companies recruit and retain key employees. The benefit of EMI options is that, in the normal course of things, employees pay no income tax on issue or exercise of the option, so they are only required to pay tax if they exercise the option and sell the shares for a gain. The rules relating to EMI options have changed recently to allow employees with EMI options to receive entrepreneurs’ relief on the sale of the shares arising from options. This means that when the employee sells the shares, provided they have held the options for at least one year, any capital gain would be taxed at a rate of 10% (as opposed to 18% or 28%). The employee must still be employed by the company at the time of sale of the shares, but (unlike for normal entrepreneurs’ relief) the relief is available regardless of the number of shares they hold.
As noted above, using an option means that no shares are issued until the option is exercised and EMI offers a large degree of flexibility over when exercise can occur. EMI options can be granted over non- voting shares and shares with the sorts of restrictions noted above (eg restrictions on transfer and sale on retirement) which ensure protection of the family shareholders.
Employee shareholder status
Another recent development is the introduction of Employee Shareholder status (ESS). This has received mixed press coverage because the premise is that employees give up certain employment rights in return for receiving shares in the company. However, ESS is beginning to attract attention, due to the fact that the tax advantages are so generous: when the employee sells their shares they pay no capital gains tax. There are also exemptions from income tax if the company buys back the shares. As noted above, concerns about loss of control can largely be addressed by issuing non-voting shares and ensuring that shares must be sold back by the employee when he or she leaves the company.