Setting the Scene

When business owners are asked if they intend to bring key staff into the company shareholding fold, the response is often along the lines of: “No, I was going to see them right when the deal gets done.”

This response is wrong, or at least short-sighted, on several levels.

A business with ambition to grow and make an exit – be it trade sale, management buy-out, private equity buy-in or maybe floatation – needs a highly committed and motivated team. No entrepreneur can make a successful journey to exit on their own. Engaging and ultimately rewarding the team for helping you achieve that success is vital.

So, what we need is a reward mechanism that:

Is tangible now
creates a sense of inclusion and importance
is not just short term
elicits the right behaviours
helps retain great staff for the long haul
is flexible and tax efficient

Many business owners think about this issue in terms of bonuses and want to keep their equity closely guarded. Bonuses fail on a number of the above counts. It would be difficult to structure a bonus scheme that would work effectively over the long term and without seeing much of it swallowed up by income tax and NI.

Stick to bonuses for rewarding short term target delivery.

Use equity to get that higher level of buy-in and commitment.

Why would I offer shares?

As an owner, giving your key people access to equity – be it directly or via options – is the ultimate way of saying:

“You are important to me and this business, I value what you are doing to help make it a success and I’d like you to share in the profits we stand to make if we achieve that success”.

Your key people become owners as well as employees and their relationship with you and the business has changed radically and potentially for the better, indeed much better. They are now no longer in it for what they can take from you and the business month by month, year by year. They have a lasting stake and good reason to stay for the whole ride.

One less obvious benefit of shares over bonus or enhanced salary payments is there is no cash cost to the company.

Are there any circumstances when you should not offer shares?

Equity is not the answer in all situations. For businesses with no prospect or intention of building for a sale, a small amount of equity can be a fairly meaningless thing. How and when does the holder get value from the shares?

“Good leaver” provisions in shareholder agreements and the company Articles that require departing employees or deceased shareholders estates to offer their shares for sale at market value are all very well, but in no way do they guarantee there will be a willing buyer on hand with the cash. Agreeing the share valuation can be expensive and messy too.

Issuing shares can give an expectation of dividends, but this can be managed by using different classes of shares for employees and founders/family.

So, awarding shares or share options that have no immediate value or potential for realisable value is probably going to be counter-productive as well as a waste of time and money.

I still want to go ahead. What are my options?

As identified above, giving an employee actual shares has some potential problems.

If the employee choses to leave, how do you get the shares back if you don’t want them to keep them? This can be addressed in the company Articles with “bad leaver” provisions which require ex-employee shareholders to transfer shares at par value or what they paid for them – i.e. not market value.

This raises another problem with issuing shares – namely the shares issued have to be paid for. Issuing shares at an undervalue will trigger a benefit-in-kind tax liability for the employee. Issuing at market value may require a significant cash investment from the employee, who may not have the cash or the inclination to invest even more heavily in their main source of income.

Share options are a very neat way to side-step these issues while giving a legal right to equity. An option can be structured in a variety of ways but in essence, it is the “grant” of an option that gives the “grantee” or option holder the right to subscribe for a given number of shares at a future time when the option can be “exercised”. Exercise is only possible after the option has “vested” and vesting criteria can be linked to time, company performance or an event – such as the sale of company.

It is worth noting that vesting does not mean exercise must take place. Once an option has vested, the right to acquire the shares has crystallised and the option holder can exercise that right whenever he or she decides, within the constraints of any rules in the option agreement. Such rules might include an end or “lapse” date – typically ten years from grant – or automatic lapse if the employee leaves the company.

The option exercise price is a cost per share that the option holder must pay the company on issue of the shares. This is set at the time the option is granted and, in an ideal world, the shares will be worth considerably more when they are ultimately issued than the option holder has to pay for them. If exercise coincides with an exit, the option shares are acquired and sold in one transaction and the option holder receives the net proceeds.

It is also worth noting that gains made on selling shares are treated as capital gains by the tax man and currently taxed at rates well below those of income and National Insurance. With EMI options (see below) the entire gain on an option can be treated as capital and as if the option shares have been owned since grant (not exercise). If that period between grant and exercise exceeds a year, the gain is subject to Entrepreneur’s relief and taxed at only 10%.

So, to round up the pros and cons: an option that only vests if the company is sold will win out over issuing shares to an employee for the following reasons:

no initial cash outlay for the employee on grant of the option
no need to be concerned about dividend payments with an option
option holders do not have the right to participate in any shareholder business or vote on resolutions
if an employee option holder leaves, it is typical for the option to lapse completely
the exercise of the option and immediate sale of the shares requires no outlay from the employee

How do I make it happen?

To put options in place you need to go through a few basic steps:

Decide how much equity to award and to whom. Notionally allocating up to 10% of the equity is not a bad place to start. 5% would be a meaningful grant for a senior person or director, 1% or thereabouts for more junior managers.
Determine when the options will vest and lapse.
Determine if there needs to be any change to the Articles to permit the grant of options or maybe create a new class of ordinary share just for option holders (which could be a non-voting class)
Get shareholder consent to grant options. If there is a shareholders’ agreement this may need to be varied.
Get a valuation for the option shares agreed with HMRC with a suitable discount for uninfluential minority shareholdings (this may be up to 90% discount on the full market value that would apply for the company as a whole at the time of grant).
Draw up and issue the option agreements and get staff to sign and return them.
Register the options with HMRC (if they are EMI options) and declare any benefit in kind if the option exercise price is below agreed market value with the discount.
Make the annual return of employee securities to HMRC.

Some further Tips and Insights

Tax matters have been touched on above. If options are your chosen route for employees, the best approach is to issue them under the Enterprise Management Incentive (“EMI”) rules. This allows the employee to pay tax on the gain at 10% once the option has been held for a year. An EMI scheme can be set up with a set of rules and then options granted under those rules or each option agreement can be complete in itself as an “EMI” option.

With the free availability of precedents, it is possible to buy an EMI option agreement template and do it yourself or with the help of an experienced accountant.

There are firms of accountants who will manage the whole process for you for a fairly modest fee and it is worth shopping around. If you go straight to your lawyer you will get the legal side dealt with but will still need to address the valuation issue.

Company valuations by valuation experts can be expensive but HMRC certainly seems to look favourably at valuations prepared by the company itself, if they are reasonable.

Tectona Partnership will look at your situation and hold your hand through the process to make sure you get a cost-effective solution that suits your requirements.

95. How to motivate and retain key staff