Alternatives to an EMI option scheme

Introduction

While an EMI share option scheme is a popular model in many growing companies, certain types of business activities are disqualified, such as leasing, financial activities and property development. A Growth Share scheme can be the substitute incentive.

The essence of a Growth Share scheme is that a new class of shares is created for the scheme, but they do not share in any of the value of the company that was created prior to their issue; the scheme preserves all the built-up value for the existing shareholders. The Growth Shares then share in the future growth in value from the date of issue.

Let’s say the company is valued at £2 million today. The Growth Shares would have a restriction that states that when the company is sold, they only share in exit proceeds exceeding £2 million, i.e. the first £2m goes to today’s existing shareholders. Thus, the new Growth Shares have nil value to start with.

The actual scheme structure is up to the company e.g. the proceeds ‘hurdle’ could be more than £2 million if you wanted. The Growth Shares can also be non-voting, non-dividend, and subject to buyback etc

Tax

Because the Growth Shares have (effectively) zero value attached to them when issued, they can be issued to employees at a nominal price, so they are both affordable and should be free of any tax liability.

Let’s contrast that with a situation where the company issues 10% of existing ordinary shares to employees. In the example above, they would be worth some £200,000. If they were gifted to the employees, they would pay income tax on the discount, incurring a tax bill of up to £90,000.

When the company is sold (an ‘exit event’), the employees holding Growth Shares will pay capital gains tax at 10% or 20% on their proceeds and benefit from the annual CGT allowance.

Company valuation

An accountant's valuation of the company is done as at the issue date of the shares. It’s not formally approved by HMRC as with an EMI scheme, but a record of the valuation is kept for the records, so that it can be shown to HMRC when shareholder tax liabilities are assessed after an exit event. This could be a few years later so it’s important to be able to demonstrate that the valuation was properly executed and was reasonable.

Legal matters

Shares v Options: under a Growth Share scheme, the shares are issued to employees upfront, whereas under an option scheme they do not become shareholders until they can exercise their options, either after a specified date, or often only when the company is sold.

In case any employee shareholder leaves the business prior to an exit event, the company will be protected under a Growth Share scheme because the Articles provide that the board can force a buyback of their shares.

There are no legislative limits on the volume of Growth Shares that may be issued, but of course the company’s existing shareholders would have to approve the creation of the new share class, and the expansion in share numbers.

Legal documents required to set up the scheme:

• New Articles of Association
• Board minutes
• Shareholder resolutions
• Employee share subscription agreement
• Scheme Rules
• Companies House filings

Other points

The design of the structure which defines the share of proceeds or value in which the Growth Shares participate is very flexible and up to the board. In the earlier example, the company is worth £2 million at issue date and employees are issued 10% of the equity. The board could set the proceeds hurdle at the £2 million level or higher, say £3 million. You could also have a ratchet mechanism, such that if the proceeds exceed a further hurdle, the Growth Shares benefit even more e.g. between £3m and £6m proceeds, they receive their proportionate 10% share, but if the company sells for over £6 million, they get 15% of the excess over that. This encourages the employees to add as much value as possible.

SEIS/EIS – any companies that have raised funding from investors using these schemes must be very careful not to disqualify the investors’ tax relief by issuing new shares that effectively give the investors a preferential return.

Note that tax legislation may change and negatively impact Growth Shares.

Growth Shares will be classed as ‘employment related securities’ and this will require an annual return to update HMRC after each tax year.

EMI - if your company is in fact eligible for EMI, note that Growth Shares can be used in combination with EMI if you would like a proceeds hurdle as part of the scheme.

Other alternatives - a 'CSOP' (company share option plan), which is the older but less generous brother of EMI, may also be used as an EMI alternative; or an 'unapproved' or non tax-advantaged option scheme is often used for non-executive directors and consultants (more information on both is available on our website).

Jerry Davison