Rewarding and incentivising employees with capital growth shares
Capital growth shares (“growth shares”) can offer a flexible and cost-efficient way to structure employee incentives. These shares are a special class of equity that only participate in capital value once pre-determined targets (commonly referred to as the ”hurdle”) are met.
What are capital growth shares?
Growth shares (also referred to as hurdle, freezer or flowering shares) are a distinct class of ordinary shares that entitle the holder to benefit from the increase in company value above a predetermined hurdle. The hurdle acts to ring-fence a certain portion of company value for existing shareholders. For example, the hurdle used might ensure founder shareholders recover the cost of their investment before any payment is made to later shareholders.
Taking the example of a business acquisition, the initial shareholders might specify that new employee shareholders should not participate in capital until they as investors have recovered the cost of their original investment plus a suitable percentage return on the investment. In an established company, the hurdle might be the market value of the company when the growth shareholders are introduced. Ordinarily, the hurdle will be based around an objective commercial trigger value.
Due to the need for the shares to exceed the hurdle before they are entitled to any return, the initial market value of growth shares can be a lot lower than the existing class of ordinary shares, making it more affordable for employees to be provided with an equity interest in the company. For employees, there is a cost in acquiring growth shares but they do benefit from capital gains tax treatment when they ultimately dispose of their shares.
Restrictions can be placed on growth shares, for example, so they must be transferred on termination of employment or if the company is to be sold. Such restrictions are common in any private company with minority shareholders to ensure the orderly administration of the company’s shares, particularly when it comes to a sale of the company to stop employee shareholders obstructing a sale.
When are growth shares used?
Growth shares have a clear commercial purpose, which is that they only generate a return if the value of the company increases. This is why they are so suitable for employee incentives since they provide clear alignment with added shareholder value which participating employee shareholder will help create.
They are more complicated to put in place but do replicate the benefits of tax advantaged EMI or CSOP options where a company does not satisfy the conditions to use a tax advantaged share option scheme or where employees already have their maximum EMI or CSOP allowance.
Even where a tax advantaged option scheme can be used, high value shares may undermine the incentive impact of the option because it is just too expensive for the employee to acquire shares - except on a sale of the company as and when the majority shareholders may decide to sell. When it can be difficult to persuade employees that there is value in a share option, having a situation where the employee can afford to acquire option shares when they wish can enhance their perceived value and increase the incentive impact.
For existing shareholders, particularly where they are remote from the business, growth shares mean that the value of their shares is not diluted unless and until their financial return is higher than it would have been when the growth shares were issued. When shareholders can be concerned that their percentage share ownership will go down if employees have shares, capital growth shares address this concern since they will not lose any of their current economic value by offering shares to employees.
Key benefits and considerations
Benefits:
- Shareholder protection: they ring-fence the value of existing shares by not being activated until the hurdle value is exceeded.
- Tax efficiency: they can be acquired at a manageable cost with the increase in value only being chargeable to capital gains tax.
- Bespoke: they can be tailored to match the company’s specific business plan targets and can be issued by subsidiaries to align share value with the employee’s role or the performance of an individual specific employer company.
- Flexibility: avoids the conditions and restrictions of EMI and CSOP schemes (for example, the need to spend the majority of time working for the company or to exercise the options within 10 years).
Drawbacks and points of note:
- Share value: the taxable value of growth shares is calculated based on the investment “opportunity” which can be considerable for a high growth company.
- Dividends: care is required to build in dividend rights without materially increasing the initial cost of acquiring shares.
- Income tax implications: if the employee pays less than market value, income tax and possibly NICs will need to be paid on the discount whether or not the shares ultimately deliver any value.
- Recovering shares: the rights and restrictions of the shares require care to ensure employers proper management of employee shareholders, for example the shares should not be transferable without prior approval and should be recoverable if the employee no longer works for the company.
We are here to help
If you would like to discuss whether growth shares could be a good fit in your company, whether delivered through an EMI or CSOP share option scheme or by issuing shares directly, or you have any questions regarding them, please get in touch with a member of the employer solutions team or speak to your usual Azets adviser.
