Employee share incentives are a useful recruitment and retention tool and they can be extremely tax efficient. Sophisticated employees are increasingly requiring a stake in the business for which they work, as part of a reward package.
Family business owners often mistakenly believe that they can’t utilise employee incentives whilst balancing other priorities, perhaps a desire not to dilute the family’s interests, or because a sale or other exit event is not intended. Below we explore some solutions to common concerns.
We see the benefit of giving an employee a stake in the business but we are not in a position to give any shares to employees. What can we do?
Phantom Share Arrangements
If giving an employee actual shares or an option over actual shares is not possible, consider a phantom arrangement. Phantom shares are used effectively by many businesses that want to replicate the benefits of an employee share scheme but who do not wish, or are not able to use actual shares. Employees could be awarded a phantom share directly, or given an option over a phantom share.
As the name suggests, a phantom share is not a real share. However, phantom shares can be used to deliver the income benefits associated with holding real shares. For example, a phantom share could receive a payment to mirror dividend payments to actual shareholders, and it could be ‘sold’ to the company after a holding period.
Any payments made by a company in respect of a phantom scheme will be treated as income by HMRC meaning that income tax and national insurance will apply. Whilst phantom arrangements are not as tax efficient as other schemes, they should not be dismissed. Many executives will have an expectation to participate in the value that they help to add to a business and if this cannot be met, they may prefer to look elsewhere.
Growth shares can be used to ring-fence the existing value of the company, whilst providing a mechanism to share some of the growth thereafter. Essentially a growth share is a new class of share structured so that there are no rights to voting, no or limited rights to dividend and no right to share in capital until a certain amount has been distributed to the ordinary shareholders.
For example, the business is presently worth £1.5m but needs to add talent to the executive team to be able to grow further. Using a growth share arrangement the family could grant share options over shares which do not vote or receive dividends and only receive capital in the event of a distribution over £1.5m. If the business is later sold for £2.5m, the existing shareholders will share the first £1.5m of sale proceeds equally excluding the growth shareholder. The additional £1m will be shared by the existing and growth shareholder pro rata.
Growth shares could also be granted via an option arrangement including vesting criteria if desirable. Vesting criteria can be linked to anything but commonly will be linked to the executive’s personal performance objectives to ensure poor performance is not rewarded.
Growth shares can be tax efficient because any gain is treated as capital and therefore subject to Capital Gains Tax rates (currently 20% for a higher rate tax payer) instead of income tax rates (currently 40% for a higher rate tax payer). Depending on the circumstances, it is also possible that Entrepreneurs’ Relief may be available to reduce the applicable rate of Capital Gains Tax to 10%.
The family is comfortable with the idea of giving some equity to key employees but we are concerned about what would happen if the employee then sells those shares to someone we don’t approve of, or that if they die the shares would then be held by their beneficiaries. What can we do?
Before any employee incentives are granted it is important to review and, if appropriate, amend existing articles of association and any shareholders’ agreements to ensure that they are suitable following the introduction of employee shareholders.
Common amendments include restrictions on the employee shareholder’s ability to transfer shares, so that they cannot sell to whoever they choose; and compulsory transfer events so that if they leave employment for any reason their shares are automatically transferred back to principle shareholders at a price which reflects if they are a ‘good’ or ‘bad’ leaver.
Our business has been in the family for generations but our children have their own careers and don’t want to take it on. We don’t want to sell the business to just anybody but we don’t want our legacy to end here. What can we do?
Many family businesses have gone on to become successful employee owned businesses. The sale of your business to the employees via a trust arrangement provides an opportunity to ensure that the values and culture which presently define your business continue into the future in a way that couldn’t be achieved with a trade sale or management buy-out. It can also provide a mechanism to dispose of your interest tax free.
Typically, an employee owned business will not involve any employees directly owning shares. Instead the shares will be held for the benefit of the employees of the business from time to time. Amongst other advantages, this arrangement makes dealing with any leavers straightforward as the employees never hold legal title to the shares.
The relatively recent introduction of an Employee Ownership Trust (EOT), which is a type of employee benefit trust, presents an opportunity for business owners to dispose their interest to an EOT and pay no capital gains or inheritance tax on any gain. Companies owned by qualifying EOTs can also pay annual bonuses to employees, free of income tax up to the value of £3,600 per employee.