Structuring share options: How to motivate employees to work towards a sale
There are various approaches to structuring share options to motivate employees to work towards a sale, says George de Stacpoole, a corporate solicitor at law firm Seddons.
There are various approaches to structuring share options to motivate employees to work towards a sale, says George de Stacpoole, a corporate solicitor at law firm Seddons.
If you are looking to sell your company within the next five years you will need to ensure that your key employees are ‘locked in’ and motivated to work towards a sale which delivers value for shareholders. A unified approach by all stakeholders during the process of putting the company to market, and subsequently selling once a buyer is found, frequently has a positive effect on valuation and negotiations.
Although this article mainly focuses on the HMRC promoted tax advantaged schemes, there are other schemes such as Share Incentive Plans and Save As You Earn. However, these schemes are less likely to meet a young company’s objective for a sale.
There are two other approaches which do not involve the granting of options. If you gift shares then the employee either pays the market value in cash or is taxed on the value as a payroll tax; this will also dilute the share capital making the company less attractive to future investors. The alternative of bonuses is tax inefficient and can provoke arguments as to the quantum of bonus awarded.
There is no way to guarantee the retention of key employees, but financially incentivising them by allowing them to achieve a capital payment in a sale through exercising share options, without them ever accruing any rights as shareholders and at no direct cost to the company or the other shareholders, goes a long way to achieving this outcome. An option is merely a right to acquire shares at a certain price in the future. They accrue no voting rights or special treatment whilst the option is unexercised.
Option schemes may be structured so that options can be exercised pre-sale; the option holders in time exchange the options for shares and become minority shareholders. This approach can work for companies that wish to incentivise employees who then have to earn the right to become shareholders. This is most effective if the company’s strategy is long term growth and not sale. This article assumes that the option scheme is structured as ‘exit only’ (i.e. a share sale) and shares will not vest pre-sale.
Share options can be HMRC approved and tax advantaged or can be entirely bespoke but not tax-advantaged. We will consider both, but tax advantaged schemes are considerably more attractive for companies and employees benefitting from the scheme.
Any scheme will be structured with two key intents. Firstly, to retain and motivate key employees to work towards a profitable sale, focussing on building shareholder value, and secondly to minimise taxation liability for the company and the employee when certain rights are exercised at the point of sale.
The scheme should be put in place a number of years before the company is regularised and put to market. The earlier a share option scheme is put in place before a sale, the greater the return for the employee as the market value of the share is likely to be lower.
You must first identify the employees which are going to be offered options. This knowledge will be innate to the decision-makers. Secondly, you must decide if the grant of options are going to be linked to KPIs or not. If linked to KPIs over a period of time then the later options may have a higher exercise price.
Confidentiality should be considered. If it is widely known that certain employees have been offered options this may cause a degree of division within the office! We usually advise that the covering letter, inviting someone to participate, includes a short paragraph about not telling other employees for this reason.
Depending on the answers above, the next step is to consider the company’s eligibility to use certain schemes, and how those schemes can be structured.
Enterprise Management Incentive (EMI) schemes are tax advantaged and the most widely used for independent companies (i.e. not owned by or ‘under control’ of another company). They are not suitable for companies which have a turnover of more than £30M, more than 250 employees and practicing a ‘non-qualifying’ trade (typically a business which is considered to be less risky such as one that provides health care; invests in property or is a professional services or financial services business).
If the company wants to give more than £3M options generally or wants to give one individual more than the £250,000 worth of options then it is also not appropriate. Most companies will qualify for EMI, but the trajectory has to be considered – if the company will in the future no longer be eligible for EMI that needs to be considered and legal and tax advice should be taken.
When the decision to implement an EMI has been made the rules of the scheme need consideration. This offers the opportunity to create a bespoke set of rules which perfectly tailor the rights of the parties to achieve the objectives the founders and shareholders. The temptation to draft them quite restrictively should be avoided as it may damage the relationship with the employees which is the opposite of the company’s wishes.
For example, having the option lapse immediately on death or the employee leaving the company for any reason whatsoever may look ungenerous, especially to employees with a family. You should consider having a period of time in which the option can be exercised after death by the employee’s personal representatives. This principle also applies for employees leaving the company as a ‘good leaver’ or in other instances such as injury, ill health, disability or retirement.
Turning to tax, there is no income tax or National Insurance Contributions (NIC) to pay on the date of grant of an option. On exercise, if the exercise price of each share was at market value on the day the option was granted there will be no tax to pay. However, if the option is granted at a discount to market value, there will be income tax and NIC payable at exercise on the amount of the original discount. For that reason, companies usually ensure that the exercise price is always market value at the date of grant and an accountant is instructed to determine what the market value is.
A company may decide that the goodwill generated from granting options with a discount, or even at a nil exercise price makes the slightly more complicated tax position worthwhile. If a company opts for this, we would recommend that the employee indemnifies the company for any taxation liability which falls on the company in return for this generosity.
Following exercise of the option, the shares would be instantly sold and the increase in value from the market value at date of grant will be liable to CGT, which is currently 20% rate of tax. An employee may be able to claim Entrepreneurs’ Relief which reduces CGT to 10%. Employees can use their annual exemption (£12,000 for 19/20) to further reduce this liability.
If an EMI scheme is inappropriate, then a Company Share Option Plan (CSOP) might be used. This is another HMRC approved tax-efficient scheme, mainly used by companies which are too large to take advantage of the EMI scheme; there are no limits to company size or employees.
However, companies can find CSOPs to be more restrictive than EMI as options can only be granted at market value – which means a valuation has to be conducted and the scheme registered with HMRC. Each employee may only be granted up to £30,000 options and the option must be held for more than three years in order for the gain to be exempt from income tax. So consider whether a trade sale is imminent.
As with EMI, there is no tax to pay on grant or on exercise (providing certain conditions are met) and the sale of the shares is subject to CGT; the annual exemption can be used.
CSOP options can be subject to any KPIs providing these are objective and stated in the option agreement and can be used in conjunction with non-qualifying option schemes (discussed below).
An entirely bespoke scheme
If neither scheme is appropriate then a company can draft its own bespoke share option scheme for the same objective. The structural considerations will be the same as addressed above but as it cannot be HMRC approved it will not have a qualifying tax favoured status like EMI or CSOP.
There is no tax to pay on the grant of the option. On exercise of the option, income tax will be charged on the difference between the market value of the shares at the date of exercise of the option and the option exercise price. There may be withholding obligations if the options are regarded as ‘readily convertible assets’ (RCAs) and legal advice should be taken on this point. If they are RCAs, then there will be NIC liabilities for the employer and employee.
When the share acquired by the unapproved scheme is then sold the employee pays CGT on the gain in value for the period in which the shares (not the option) has been owned by the employee. The annual exemption for CGT can be used.
Young, growing companies have plenty of opportunities to structure share options in specific ways to motivate employees to work towards a sale due to the flexibility outlined above but carrying none of the taxation and documentary clutter associated with other forms of bonuses and emoluments.
An option can be awarded to an employee at no cost and the rules regulating that relationship can be an entirely bespoke document which caters for the nuances for the company and the employees.