Sweat Equity

In the 19th Century, the idea that workers who invested their skills and labour might also share in the capital growth of a company was virtually unheard of. Things have moved on a bit since then. Today, a growing number of companies recognise that in a highly competitive market, with costs under constant pressure, the key to sustainable competitive advantage lies in getting the best out of its people. One way of doing this is to offer directors, employees and others the opportunity to become part owners and so share in that growth. This article examines how this is done and the potential pit falls that wait the unwary.

Why would sharing equity be good for you?

You can use equity to achieve a number of advantages for your company as follows:

• To raise funds for your company without increasing debt;
• To attract and retain good employees, partners and co-directors who will make a real contribution to the growth of your business;
• To encourage longer-term loyalty, particularly if rights are forfeited if the employee leaves;
• To enable the employees as part owners of your company to identify more closely with the medium to long-term future objectives of your company rather than the short-term objectives of maximising their own take-home pay;
• By attaching performance conditions, to add an additional incentive for future good performance;
• By adding a requirement that rights only vest on a future sale or listing of the company, to focus management’s efforts to achieve an exit;
• To provide a tax efficient form of remuneration; and
• To enable cash poor companies to compensate employees, partners, directors and service providers and in doing to grow rapidly and to compete with larger concerns.

What do we mean by ‘sweat equity’?

Sweat equity is a term used to describe the award of shares or grant of share options to a participant in consideration for their time, knowledge and other efforts contributed to the company. Unlike financial equity where the participant pays for the shares in cash, it usually reflects the person’s human contribution to the company – the value of which will need to be agreed by the parties concerned.

It can reward the efforts put into a start-up company by the founders, or those joining during the company’s early life. Employees might receive sweat equity in return for working for little or even no salary. It can also be used to pay (in full or part) for goods or services provided to the company.

What are you trying to achieve?

There are a number of ways of sharing the equity, but which one best meets your needs? The starting point in every case is to identify your objectives and to then consider, of the choices and schemes available to your company, which one best meets those objectives. Tax efficiency is always important but this still needs to be balanced against your other commercial objectives.

Should you award shares immediately or grant a share option?

A share award can be by way of simple allotment of new shares or transfer of existing shares. Alternatively, it can be part of a more complex but tax advantageous share scheme.

A share option is where the participant is given a right to acquire the shares at an agreed price after an agreed date in the future, upon the terms of the relevant share option scheme. Unlike an immediate award of the shares, the optionholder will not actually own the shares at this stage and will not therefore have any shareholder rights. To become a shareholder, the optionholder must first exercise the option and pay for the shares, subject to complying with the terms of the related share option scheme, which will include provisions on when the options become exercisable.

There are various considerations affecting whether to award shares immediately or to grant share options:

• Dilution: If you don’t wish to dilute the current shareholdings immediately then a share option is preferable. However, this will be less of a concern if you have already set aside a percentage of shares for this purpose.

• Dividends: If you want the participant to receive dividends, then an immediate share award is preferable. It is technically possible to pay optionholders a dividend equivalent payment but this is not tax efficient and should be avoided. If dividends are unlikely, then this isn’t an issue.

• Aligning interests with the shareholders: Participants with shares will be more aligned to the shareholders, particularly if they have paid for the shares and have put their own capital at risk. They will also be able to vote and generally participate as a shareholder in the company. Participants with share options do not put their capital at risk until exercise and there will be no risk at all if they only exercise the option on a company sale.

• Market value of the shares: When directors and employees acquire shares, they will be subject to the relatively complicated ‘employment related securities’ regime. If the market value of the shares is low (e.g. the company has just started trading) then it should be financially realistic and tax efficient to award the shares immediately. However, if the shares have some value then one of the more tax efficient share schemes may be preferable.

Tax advantages

If you decide to award shares under a tax advantageous scheme or grant a share option, what type of share scheme should you go for?

You often hear share schemes described as ‘approved’or ‘unapproved’. An ‘approvedscheme’is essentially one that is drafted in accordance with the requirements of the particular tax legislation (set out in the schedules to the Income Tax (Earnings & Pensions) Act 2003 (“ITEPA”) as amended). The advantage of this is that it provides the tax benefits applicable to that scheme. The disadvantage is it makes the scheme less flexible.

An ‘unapprovedscheme’conversely has the disadvantage that it does not offer any particular tax benefits. However, it does offer the most flexibility and can be drafted on almost any terms you want. Consequently, it can be useful where the approved schemes are unavailable or insufficient to meet the company’s objectives.

Popular ‘approved’ schemes

Enterprise Management Incentives (“EMI”) – Schedule 5 ITEPA

This is a type of share option scheme available to independent companies (with gross assets not exceeding £30 million and carrying on qualifying activities) and can be offered to selected employees. It benefits from being an extremely flexible scheme and is therefore the most popular of the approved schemes. There is no need for EMI to be formally approved by HM Revenue & Customs (“HMRC”) before grant, exercise can be set at less than market value at grant (although this will give rise to an income tax charge on the discount at exercise), the option shares can be subject to greater restrictions than for other schemes, there is no minimum holding period to obtain the tax benefits and each employee can hold unexercised options over £120,000 worth of shares valued at the time of grant (with a £3 million overall limit for all employees).

Company Share Option Plan (“CSOP”) – Schedule 4 ITEPA

This is a type of share option scheme available to independent companies and can be offered to selected employees. However, the CSOP must be formally approved by HMRC before options can be granted, there is a £30,000 limit per employee on the value of the shares under option, the exercise price may not be less than market value at the time of grant, the options cannot generally be exercised within the first three years after grant, only certain permitted restrictions can attach to the shares and the legislation is quite restrictive. [Why would any one use this over an EMI scheme?]

Save as you earn Scheme (“SAYE”) – Schedule 3 ITEPA

This is a type of share option scheme available to independent companies but must be offered to almost all employees. It enables companies to grant share options to employees at a discount of up to 20% to market value at the time of grant. The employee must enter into a savings contact for the duration of the option and at the end of the savings period the employee receives a tax-free bonus on the savings which he can either withdraw as cash (in which case the options lapse) or use to fund the exercise price for the shares. However, the SAYE must be formally approved by HMRC before options can be granted, it is more complex to administer, savings are limited to up to only £250 per month and must be made from after-tax pay and only certain permitted restrictions can attach to the shares.

Share Incentive Plan (“SIP”) – Schedule 2 ITEPA

This is one of the most tax advantaged share plans available to independent companies but must be offered to almost all employees. This is not actually a share option but an award of shares. It has the flexibility to offer all or a combination of up to £3,000 free shares, £1,500 partnership shares (paid for out of the employees’ pre-tax salary), £3,000 matching shares and £1,500 dividend shares per tax year – so maximum awards are quite limited. SIP needs to be administered by a UK trust which makes this a complex and expensive plan to set up. Consequently, SIP is more suited to large companies with many employees.

What are the key documents when granting options/issuing shares?

Whether you grant options or award shares immediately it is vital you properly document and structure the rights and obligations of the parties. This is required to address issues that might otherwise develop into misunderstandings at a later stage. If you adopt a share scheme, a carefully drawn written agreement is also required if you wish to receive the tax benefits applicable to that scheme.

The principle documents you need to think about are:

Share Scheme Documents

This is only required, of course, if you chose to award shares or grant options under a share scheme.

The format of this will very much depend upon the type of share scheme being adopted. An unapproved scheme can be drafted on almost any terms you want, whereas the approved schemes must also comply with the related tax legislation if you want to receive the related tax benefits.

Usually, this will take the form of an umbrella scheme (setting out the general rules) and individual agreements with participants (setting out the specific terms of the share options or awards applicable to each participant).

Articles of Association

Every company in England and Wales must have articles of association setting out, amongst other things, the rights attaching to the shares and the conduct of directors and shareholders’ meetings.

If you adopt an approved share scheme, then it is important to review and, if necessary, amend the company’s articles to ensure the rights and restrictions attaching to the shares comply with the related tax legislation.

You should of course note that sharing the equity will mean your company will gain further shareholders, most probably having a minority holding. It is therefore important that you consider the rights and obligations of the shareholders as a whole and what special rights or restrictions (if any) are required. Most company’s choose to put in place a package of rights and restrictions to ensure that minority shareholders are “tied in” and cannot unduly influence the way the company is run. It is not within the scope of this article to set out all the commonly used packages, but they tend to include the following: pre-emption rights on the issue and/or transfer of shares (to restrict dilution), drag-along and tag-along rights (to ensure that all shareholders participate in a future company sale) and compulsory transfer provisions (should a shareholder cease to be employed by the company, die or go bankrupt).

Shareholders’ Agreement

Companies in England and Wales are governed by the Companies Acts and their articles of association. A shareholders’ agreement creates an additional set of contractual rights and obligations that overlay, and often suspend or modify the effect of, the ‘default’ rules set out in the Companies Acts and the articles.

Parties don’t have to enter into a shareholders’ agreement but it can be a very useful and often essential document to set out agreed matters between the parties relating to the business, conduct and management of the company and the respective rights and obligations of the shareholders. For instance, this could include further funding obligations, non-compete restrictions and minority protection. This should help protect the value of the company (and consequently the shareholders’ investments) and minimise the potential for disputes.

A number of matters dealt with in a shareholders’ agreement could be dealt with in a company’s articles. However, it is often more appropriate to capture these in a shareholders’ agreement because a shareholders’ agreement (unlike the articles) is a private document and does not need to be filed at Companies House. Furthermore, as a direct contract between the shareholders it can be enforced more easily by a shareholder party against the other shareholder parties.

What are the main related tax issues you need to think about?

The main objective of tax planning will typically be to ensure that tax liabilities do not arise before shares are sold and cash proceeds of sale are received; and to ensure that any such realisation falls within the capital gains tax regime (with a normal rate of 18%) rather than an income tax regime (with the top rate soon to be 50%) and also potential national insurance liabilities.

Whenever shares are acquired by an employee or director, income tax and national insurance issues must be considered. In this context it should be noted that there is a rather crude provision in tax legislation. This treats shares acquired by someone who is, or is to be, an employee or director of the company as acquired by reason of employment of directorship. This applies even where the reality is that the shares are not a reward of employment and the individual is, for example, acquiring the shares as the founder or otherwise in an entrepreneurial capacity.

In any case where shares are acquired by reason of employment, or treated as acquired for this reason under the above legislation, potential exposure to income tax and national insurance liabilities arise. Some of the main circumstances to be aware of in this context are as follows:

• where shares are acquired at less than market value (e.g. if employees are given shares as “sweat equity” at a time when those shares have a value) or where shares are acquired on the exercise of a share option for a price less than the value at the date of exercise;
• where shares are subject to restrictions (e.g. on transferability or under which shares can be forfeited) which cease to exist;
• where shares are converted into shares having more valuable rights;
• where arrangements artificially enhance the value of the shares;
• where the employee/director receives a benefit in connection with the shares not provided to all shareholders.

Each of the above circumstances carries with them the potential for income tax and national insurance liabilities before shares are sold (e.g. an immediate charge at the time shares are acquired on the excess of the value of the shares over any amount paid for the shares). Effective planning can often best be achieved by ensuring (if this is possible) that shares are acquired before they have any material value. If the shares have to be earned (e.g. by a period of employment or by satisfying other performance conditions), then it is often possible to structure the arrangements so that the shares are subsequently forfeited if those conditions are not satisfied. With careful structuring and the making of appropriate tax elections, the tax charges applying to shares which are subject to restrictions can usually be avoided.

In cases where an immediate acquisition of shares does not avoid tax problems (either because of share values or because there are commercial reasons why it is not appropriate for employees to own shares from the outset), then share options or some other form of share incentive scheme (as referred to above) may need to be considered. In order to secure tax efficiency, it is then necessary to establish whether the requirements for adoption of one of the tax advantaged forms of share scheme can be satisfied. For example, if share options are to be used, the main objective of using an EMI option or a CSOP option will be to avoid an income tax liability arising at the time of exercise of the option (when the shares are likely to have a value greater than the exercise price).

The main tax issues which the company will need to consider (quite apart from its interest in establishing an arrangement which is tax efficient for its employees) are:

• Reviewing exposure to national insurance liabilities, in view of the potential liability to employer’s national insurance

• Considering whether there are potential income tax and national insurance liabilities for the employees which are the responsibility of the company to collect and pay over to HMRC under the Pay As You Earn system. These liabilities can arise in circumstances where no, or insufficient, cash payments are being made to the employee from which to deduct the relevant income tax and national insurance; in which case special arrangements need to be established from the outset to ensure that employee tax liabilities are paid or reimbursed by the employee

• Considering whether any value “given away” to employees gives rise to a corporation tax deduction. For example, there are provisions which can result in any amount which is subjected to income tax in the employee’s hands being the subject of a corporation tax deduction

The employing company should also be aware of reporting obligations relating to shares or options acquired, or treated as acquired, by reason of employment. One such obligation is to report the acquisition (whether or not it gives rise to any tax charge) before 7 July in the tax year following the tax year in which the acquisition takes place.

Final thoughts

Although this is an area of some complexity, with potential traps for the unwary, a well structured employee share incentive arrangement can be very tax efficient. The starting point is to understand the aims and objectives of any particular proposal. Equipped with this information it is usually possible to devise a structure which achieves the commercial aims and also secures tax efficiency.