Growth shares are a long-standing solution to allow employees to benefit from share ownership without an insurmountable upfront cost.
In contrast to share options (other than EMI or CSOP), growth shares allow employees to become shareholders immediately on terms which can be tailored by the company to provide an effective incentive to grow its value.
The tax treatment is also much less costly, which is important for private companies where the exercise of an option can – in the absence of a market for the shares received – lead to the employee needing to pay a significant amount in tax but without receiving any cash out of which to pay it. The result will be a “dry” tax charge with an actual cash outflow for the employee and this is the key problem growth shares are often used to address.
What is a growth share?
Growth shares are ordinary shares in the capital of a company, but where the rights are limited so that on a sale (or other realisation event), the holder will only receive a share in the value of the company above a threshold.
- For example, say a company has 99 shares and is worth £10m. A single new growth share might be issued to an employee representing 1% of the share capital of the company.
- However, that growth share would only have a right to participate in value above £12m.
- So, the initial value of the growth share would be negligible on award because it has no right to any of the current value of the company. As a natural consequence, the income tax charged on award would therefore be very low.
- However, if the company were subsequently sold for £20m, the growth share would have a right to 1% of the value in excess of £12m – i.e. £80,000. The gain in value would be charged to CGT on realisation in the same way as for other shareholders.
Because the rights attaching to growth shares are entirely up to the company and its shareholders, they can be as simple or complex as desired. The example set out above is a straightforward arrangement but it is not unusual to use e.g. a “ratchet” structure in which holders of growth shares are rewarded for hitting particular targets – so the class of growth shares might be entitled to 1% of value above £12m, but, say, 5% of value above £18m.
The initial valuation of a growth share is therefore key and should be thought through carefully from the outset when deciding on the structure used. As HMRC will no longer agree valuations for this purpose it is important that there is a clear record of how and why the value used was determined in order to avoid future challenges (either from HMRC or on pre-sale due diligence).
Growth shares may have the same voting and dividend rights as other shareholders, or have no rights at all beyond receiving a proportion of value on an exit, as is commercially preferred.
There is also scope for individual performance conditions (although these will not impact the valuation) and “good” and “bad” leaver provisions.
The growth share concept operates most naturally for private companies, particularly companies which have grown beyond the limits for EMI, or private equity backed companies where significant debt also results in a low initial equity value and substantial growth prospects. Equally, they have been successfully used by listed companies either over shares in the listed parent or in subsidiaries.
How Pett Franklin can help
- Design of growth share schemes;
- Structuring of share rights;
- Valuation analysis to reach a basis on which to operate tax;
- Tax analysis of the plans and the related reliefs;
- Financial modelling; and
- Legal documentation.