Shoots Slides

Rewarding employees and di t ith itdirectors with equity

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Growth | International | Protecting | Restructuring www.taylorvinters.com

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R di l d di t Rewarding employees and directors with equity

Quentin GolderPartner

Karl PocockConsultantPartner

Taylor VintersEntrepreneurial Business Team

ConsultantTaylor Vinters

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www.taylorvinters.com

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Wh it ?Why equity?

• Effective incentive:

- studies indicate companies with employee share schemes out-perform p p y pcompanies without, often by significant margins

• Tax advantages:

- for both company and employee- capital versus income- NIC savings

• Cashflow advantages:

- a company can provide a benefit to employees without having to fund it with cashcash

• Potential windfall gain for employees on exitLAWYERS WITH A


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Sh tiShares versus options

Shares (pros):

- actual ownership versus right to acquire actual ownership versus right to acquire

- potential for dividends

voting rights- voting rights

- right to attend general meetings

- cash commitment from employee

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Shares (cons):

- shares must be paid forp

- income tax issues if acquired for less than market value

- what to do if the employee leaves?- what to do if the employee leaves?

- dispersed shareholding can be an administrative hassle

l l bl f h l- logistical problems on further investment or sale

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Options (pros):Options (pros):

- no need for employee to part with cash on grant

can still provide equity windfall- can still provide equity windfall

- on ceasing employment options can lapse

- no issues regarding voting

- can be tax efficient for employer and employee

- flexible – can be made subject to conditions, and tailored to particular employees

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Options (cons):Options (cons):

- may not create same sense of commitment

no voting/dividend rights- no voting/dividend rights

- conditions on exercise can be beyond employee control

- if share value drops then essentially unexercisable

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Attit d f i t t l Attitude of investors to employee equity

• Incentivising management/employees generally seen as essential• Incentivising management/employees generally seen as essential

Typically a percentage of equity is notionally allocated for employees eg 10%• Typically a percentage of equity is notionally allocated for employees, eg 10%

• Size of awards to individuals variable depending on size and value of company

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H t t h ( d t How to get shares (as opposed to options) into employee hands?• Allot at early stage, while values low

• Use HMRC approved schemes eg• Use HMRC approved schemes eg

- SIP

SAYE- SAYE

(but limitations)

• LTIPs (generally only suitable for listed companies)

• Loan to employee to pay for shares (but debt still remains)

• Pay bonus to employee to cover costs of acquisition and tax (fiscally inefficient)

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H t t h ( d t How to get shares (as opposed to options) into employee hands? Cont .

• Allot shares as unpaid (debt remains owing)Allot shares as unpaid (debt remains owing)

Use of ‘growth’ shares ie shares which only provide a return if certain financial thresholds • Use of ‘growth’ shares, ie shares which only provide a return if certain financial thresholds are achieved on a liquidity event. The share rights depress the value of shares acquired making them more affordable (not always suitable)

• Use of ‘deferred’ shares, ie investor shares converted to valueless shares if certain milestones achieved, effectively increasing the share percentages of founders/employees (limited application)

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U f tiUse of options

• Most flexible and (potentially) tax effective method to pass equity to employeesMost flexible and (potentially) tax effective method to pass equity to employees

For early stage companies in Cambridge the two most typical forms are• For early stage companies in Cambridge the two most typical forms are:

- Enterprise Management Incentives (EMI)

- Unapproved options

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EMI tiEMI options

• Company requirements:

- companies must carry on a qualifying trade in the UK (changes from 6 April)companies must carry on a qualifying trade in the UK (changes from 6 April)

- “qualifying trade” – trades that are not “excluded activities”, ie dealing in land, banking, insurance, leasing, legal, accounting, property development, farming hotels shipbuildingfarming, hotels, shipbuilding

- no more than 250 employees

h- gross assets not more than £30m

- independence – not a subsidiary of another company

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EMI optionsEMI options

C i t• Company requirements:

- limit of £3M (based on market value of shares subject to options at their date of grant) of issued options outstanding.p g

- shares must be fully paid and non-redeemable

EMI tiEMI options

• Eligible employees:Eligible employees:

- must not hold options over shares in excess of £120k at date of grant

30% material interest threshold- 30% material interest threshold

- minimum work time commitment (25 hours per week, or 75% of working time)

• Options must be exercised within 10 years

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EMI tiEMI options

Benefits:

• Flexibility – as to voting conditions of exercise priceFlexibility as to voting, conditions of exercise, price

•Tax position:

no income tax on grant- no income tax on grant

- no income tax on exercise if:

(a) a qualifying option; and

(b) there was no discount to market value at date of grant

- on sale of underlying share – CGT at 18%

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P t ti l bl ith EMI tiPotential problem with EMI options

• Disqualifying events, eg company or employee ceases to meet EMI requirements. Tax benefits lost unless option exercised within 40 days.

• Disqualifying event occurs:

- may not be realised at time

- if the option is subsequently exercised, there can be adverse tax consequences if the parties are unaware of its non-qualifying status

f k d h l b l b ld f l- if not picked up, then liability may build significantly

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EMI options – tax example (1)

O ti 100 h t £50 h i i i £5 000• Option over 100 shares at £50 per share, so exercise price is £5,000

• Market value at date of grant is £50 per share, so £5,000 in total

• Market value at exercise is £300 per share, so £30,000 in total

• Income tax due on exercise £0 (assuming exercise within 10 years and a qualifying option)

• On sale of shares, capital gains tax due on difference between exercise price and sale price

EMI options tax example (2)EMI options – tax example (2)




• On exercise income tax due £5000 (ie difference between exercise price and market value at date of )grant)

• On sale of shares, capital gains tax due on difference between market value at date of exercise and sale pricesale price

EMI options tax example (3)EMI options – tax example (3)



• Disqualifying event occurs (when market value is still £5,000), and option not exercised within 40 days


• On exercise income tax due on £25,000 (ie difference between exercise price and market value at date of disqualifying event)

• On sale of shares, capital gains tax due on difference between market value at date of exercise and sale price

U d tiUnapproved options

• Completely flexible as to termsCompletely flexible as to terms

Options can be granted over any type of shares at any price with whatever exercise • Options can be granted over any type of shares, at any price, with whatever exercise conditions as the company may impose

• No restriction on who options can be granted to

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U d tiUnapproved options

• Tax treatmentTax treatment

- no income tax on grant

on exercise income tax on the difference between the exercise price and - on exercise, income tax on the difference between the exercise price and the market value of the share on exercise (less anything paid for the grant of the option)

h h h h ld- tax charge on exercise arises whether or not shares sold

- on a subsequent sale of the shares, CGT will be payable

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R t i t d hRestricted shares

• Tax treatment

- “restricted shares” are subject to a specific tax regime when granted to restricted shares are subject to a specific tax regime when granted to employees or directors

• What are “restricted shares”?

- shares are restricted if:

(a) they can be forfeited in certain circumstances (eg on leaving the )company)

(b) a right over, or conferred by, shares is limited (eg have to sell shares to specific purchasers); or

(c) the shares impose a disadvantage on the shareholder

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R t i t d hRestricted shares

• Purpose of regime?Purpose of regime?

- without specific tax regime, income tax could be avoided by artificially reducing share values and increasing them at a time when income tax is not payablepayable

- rules can apply to innocent transactions so care needed

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R t i t d h Restricted shares

• How are restricted shares taxed?

- income tax is not chargeable on acquisition except in limited circumstancesincome tax is not chargeable on acquisition except in limited circumstances

- if restricted shares are acquired for less than their unrestricted market value income tax is charged when either:

(a) the restriction expires or is lifted or varied; or

(b) the restricted shares are sold with restrictions in place

- income tax is chargeable on the proportion of the unrestricted market value at the time of the taxable event, less any allowable expenditure

- PAYE may be operated and NICs charged depending on factsPAYE may be operated and NICs charged depending on facts

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• Example of income tax charge

(a) unrestricted market value of the shares on acquisition is 100( ) q

(b) restricted market value of the shares on acquisition is 70

(c) discount is 30% (the “chargeable proportion”)( ) ( g p p )

(d) unrestricted market value on disposal is 200

(e) income tax chargeable on 60 (ie 30% of 200)(e) income tax chargeable on 60 (ie 30% of 200)

- more complicated if only one of a number of restrictions is lifted, but can elect to treat all restrictions as lifted at that time

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• Income tax when shares have decreased in value

- Example:Example:

(a) unrestricted market value on acquisition is 100

(b) restricted market value on acquisition is 70(b) restricted market value on acquisition is 70

(c) discount is 30% (the “chargeable proportion”)

(d) unrestricted market value on disposal is 50

(e) income tax chargeable on 15 (ie 30% of 50)

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• Alternative tax treatment

- employer and employee can jointly elect for different tax treatmentemployer and employee can jointly elect for different tax treatment

• What effect does an election have?

employee subject to income tax at time the shares are issued- employee subject to income tax at time the shares are issued

- tax charge is based on the unrestricted market value of the shares less the price paid

- no further income tax will arise when restrictions lifted or shares sold (although CGT may be payable)

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• Should you make an election?

- Pros:Pros:

(a) upfront tax charge is known and may be affordable

(b) potential tax saving if unrestricted value increases considerably(b) potential tax saving if unrestricted value increases considerably

- Cons:

(a) employee may forfeit shares even though paid the tax

(b) shares may not increase in value so tax paid higher than if no election

(c) will have to find cash as no disposal proceeds

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Taylor VintersMerlin PlaceMilton RoadCambridgeCB4 0DP

01223 423444

Taylor Vinters is regulated by the Solicitors Regulation Authority (SRA Number 67782) and is authorised and regulated by the Financial Services Authority for investment business. This firm is regulated by the Solicitors Regulation Authority and authorised and regulated by the Financial Services Authority for investment business. www.taylorvinters.com