How can growth shares benefit your business?

Companies could be looking towards tax-efficient ways to incentivise staff in the New Year. In the current market, private limited companies often consider growth shares, either for commercial reasons or because the company does not meet the statutory requirements for traditional Enterprise Management Incentive (EMI) or company share option plans.

What are growth shares?

Unlike employee share options, growth shares are issued upfront to employees, usually at nominal value. There are no restrictions on which companies can issue growth shares, nor on the number or type of recipients. On the face of it, they look remarkably simple to grant and incentivise recipients to grow the business.

The intention of growth shares is to reward those engaged in the business, whether as employees, consultants or contractors, who have worked towards a profitable exit and, in many cases, remain with the company at the point of that exit.

The holders of growth shares generally do not have a right to vote, nor participate in any return of capital, until the proceeds on an exit exceed a ‘hurdle rate’. It is possible that in certain cases they might be entitled to a dividend. The holder of growth shares is therefore incentivised to grow the business with a share in the future capital growth of the business on sale. Unlike employee options, which are entitled to a percentage of all of the proceeds on a sale, growth shares are only entitled to a percentage of the proceeds exceeding the hurdle rate and therefore only dilute the economic interest of the other shareholders at that point. As growth shares have no voting rights, there is no dilution on statutory voting matters at all.

The hurdle rate should, with the help of an independent valuation by qualified accountants, exceed the value of the company at the date of grant, so that there is little intrinsic value to the growth shares on issue, and therefore little or no taxation on the employee at issue. The value of the growth share is only crystalised at the point of exit.

Unlike other share options, the rights and obligations attaching to the growth shares are set out in the articles of association (“the articles”). They may require insertion into a shareholders’ agreement and sometimes a separate subscription deed for each recipient. Shareholder consent is required before they are issued. If an employee negotiates other liquidity triggers, things start to get complicated. Good leaver/bad leaver provisions, negotiations surrounding partial exit, vesting and buyback can add layers of complexity, and careful consideration needs to be given to the drafting of the articles to avoid ambiguity, adverse tax consequences or disputes with departing employees.

Growth shares and employee leavers

The usual practice is that employee leavers should not be able to cash out before other shareholders. Receiving market value for growth shares at the end of employment without cause may prove more lucrative for the employee than staying in the business if the hurdle rate cannot be attained on an exit. The company could argue that the sale price for the shares of the leaver is to be based upon a valuation of the company at that time and apply the hurdle rate to determine if any purchase price is payable, but this could incur costly and potentially frequent valuation exercises.

Where commercial drivers dictate that the growth shares will have some value at issue, the shares can be issued on a ‘nil paid’ basis, where the employee agrees to pay an amount equal to initial value for the shares but is not required to pay that amount until a later event occurs. Nil paid growth shares will require payment by the employee on an exit, or in some cases prior to an exit, which may not equal the proceeds they receive. Asking a departing employee to pay up for worthless equity upon termination of their employment is at best challenging, at worst impossible. Releasing the employee from the requirement to pay will have payroll tax implications for the employee and employer. Alternatively, offering employees holding options the right (but not the obligation) to pay an exercise price to subscribe for shares, or the options lapse, is far easier to implement.

As negotiations for the rights attaching to the growth shares become protracted (which would rarely arise under a standard EMI share option scheme), costs can spiral and trust between key employees and the board can break down. Recipients of growth shares should recognise an alignment with management towards maximising exit proceeds and strive to keep the terms simple and reduce costs of implementation.

The most basic solution is to ensure that growth shares are paid for at the point of issue (setting the hurdle rate to minimise that payment), and only pay out on an exit in excess of the hurdle rate and if the employee/consultant adviser is still engaged by the company at that time.

If you have questions about growth shares, please contact Catherine Williams and Paul McCourt.