Growth Shares: Why so popular?

How do growth shares work?

Growth shares can be a useful way of getting equity into the hands of a key employee.

Growth shares are a special class of shares. They are usually used where the company has a significant value. Before the growth shares are issued the rights of the existing shares are altered so substantially all of the value of the company at that point is reflected in the value of those shares. The growth shares are only entitled to participate in the proceeds of sale of the company above the value of the company when the growth shares are issued.

As the growth shares would not be entitled to any significant sum if the company were sold shortly after they have been issued, the growth shares have a very low value when they are acquired. This means the employee can participate in the future growth in the value of the company without having to pay a huge amount for his shares and/or suffer a significant income tax charge when he acquires them.

Consider a company that has a current value of £10m and growth shares that are entitled to 20% of the value of the company above £10m. If the company is eventually sold for £20m then the employee would be entitled to £2m (20% of £10m). If the employee were given 1% of the share capital of the company he would also receive £2m (before CGT), but he would have suffered an income tax charge based upon 1% of £10m (subject to reduction for a minority holding, etc) in the year the shares were acquired.

Key characteristics of growth shares

If they are structured correctly growth shares have the following key characteristics:

1. There is no income tax or NICs when they are acquired;

2. The shares are held from the date the shares are issued. That means entrepreneurs` relief might be available. Contrast that with the use of an option (for example under the enterprise management scheme (EMI)) where the shares are not actually acquired until some time after the option is granted;

3. The employee only receives a significant sum in relation to the shares if the value of the company grows after he has held his shares;

4. The gain on the shares is subject to capital gains tax (CGT). That is likely to be lower than income tax. If entrepreneurs` relief is available, the effective rate of CGT on the gain can be as low as 10%; and

5. The gain on the shares cannot be treated as deductible in calculating the corporation tax of the employing company. Contrast that with a cash bonus or an EMI option where the bonus or the gain on the value of the shares from the date of grant of the option to the date the shares are acquired can qualify for a corporation tax deduction. This is often the major disadvantage of using growth shares.

Corporate Law Issues

The employee will become a shareholder. The existing shareholders can protect their position by ensuring that:

1. the growth shares have no or restricted voting rights;

2. the growth shares have no or restricted dividend rights;

3. the employee has to sell his shares if he leaves employment; and

4. the employee can be forced to sell his shares if the other shareholders want to sell theirs.

Growth Shares: Why so popular?

We are seeing increased use of growth shares. We believe this is for the following reasons:

1. They are a good incentive mechanism. If there is no growth in the value of the company, the employee gets no or little value from his growth shares;

2. They can produce a very favourable tax outcome for the employee, including no income tax or NICs on acquisition and obtaining entrepreneurs` relief when they are sold;

3. Companies seem amenable to sacrificing their corporation tax deduction (which would be available if a cash bonus were paid or EMI options were used) for the benefit of the employee's favourable tax treatment;

4. They rely upon general tax and company law principles. It sometimes is not possible or commercially advantageous to satisfy the conditions for a tax-favoured share scheme like EMI or CSOP;

5. The employee-related securities tax regime has been in force since 2003 and many professionals are now comfortable with the way it works; and

6. With proper legal documentation the employee cannot disrupt the running of a company or its sale by virtue being a shareholder.

If you have any questions about growth shares, EMI, share schemes or any other tax issues, please contact Nasim Sharf on 01482 337336, email moc.s1732458339tillo1732458339r@fra1732458339hs.mi1732458339san1732458339.

This article is for general guidance only. It provides useful information in a concise form. Action should not be taken without obtaining specific legal advice.