We’ve Been Thinking About Growth Shares

Typical example

Company X Ltd wants to incentivise a new sales director with shares. X Ltd wants to award the director 5% of the issued share capital. X Ltd has 1,000 shares in issue and a recent external investment valued the company at £100,000 i.e. the investor paid £100 per share.

Unless the sales director was willing to pay market value for the 5% award (i.e. £5,000), issuing shares in this way would give rise income tax (and possibly NICs) on the difference between the market value and the amount actually paid.

Acquiring the shares in this way would give rise to what is commonly referred to as a “dry” tax charge i.e. a tax liability which is payable even though the sales director would not have received any value for the shares at that time.

The key objectives of structuring an efficient growth share plan is, therefore (1) to ensure that the eventual sale of shares is taxed as capital (not income), and (2) to issue the shares in a way that they have a nominal (ideally nil) value at the time of issue so that the income tax payable (if any) on acquisition is not commercially unattractive for the participant.

How to structure growth shares?

Growth shares involve creating a new special class of shares.

The articles of the company need to be amended to create a new class of shares which entitle the holders of those shares (i.e. the growth share participants) to receive proceeds on an exit (the parameters of which are to be determined on a case by case basis).

The growth shares will usually participate pro-rata with the ordinary shares after the holders of ordinary shares have received the “hurdle” value.

Using the example above, if the hurdle value was set at £500,000 and the shares of X Ltd were sold for £750,000, the sales director would receive £12,500 (5% of £250,000). If X Ltd was sold for £400,000, the sales director would receive nothing for the shares and they would likely be bought back by the company (at nominal value) and cancelled prior to a sale occurring.

In order to create a modest value for the growth shares at the time of issue, companies will need to set the hurdle to a value that is higher than the market value of the shares at the date of issue. Provided the shares only participate in the growth above the “day 1” market value and the hurdle is set at a sufficiently high level, the growth shares should only have a modest value (if any) on issue and therefore only attract a nominal income tax charge (if any).

It is necessary for X Ltd to obtain a valuation of the company in order to set the appropriate hurdle value and to minimise any income tax charges arising on the date of issue. Since 6 April 2016 HMRC have withdrawn the facility to agree share valuations after the event so it is necessary for companies and participants to retain a contemporaneous valuation in order to be able to rebut subsequent queries from HMRC. A query might arise, for example, when the sales director declares the receipt of the shares in their next personal tax return.

It may also be possible to structure the growth shares so that they benefit from Entrepreneurs’ Relief (ER). If available, this means that the gain made on the sale of the growth shares could be taxed at a fixed rate of 10%. There are various requirements for the shares to qualify for ER, most notably that the participant needs to hold 5% of the nominal value and 5% of the voting rights. The nominal value requirement is often easy to overcome but companies are often keen to avoid giving up 5% of the voting rights to a single growth share participant.

Should I put growth shares in place?

If you are an owner of a private company and want to provide incentives for key staff, growth shares could be an attractive route, particularly where other HMRC approved schemes such as EMI are not available. Growth shares can be suitable for consultants and non-executive directors and for start-up companies with a low value but significant growth prospects.

We have extensive experience in structuring growth share schemes and are well placed to advise on the corporate and tax aspects. If you are considering putting in place a growth share scheme, please get in touch to discuss.

The content of this article is for general information only and is not intended to constitute or contain legal or other advice.