Key employees often drive the growth in value of a company. Increasingly, one of the best ways to help recruit the right team and motivate them to do this is to give them a share in this increase in value in the business. ‘Growth’ shares are a great way of achieving this.
At their most basic, growth shares are a separate class of incentive share that entitles the holder to benefit in the future growth in value of a business, but typically only on a company exit (sale) event.
The key difference between growth shares and ‘ordinary’ shares is that the recipient only usually benefits in the value of a business, above a set ‘hurdle’ level rather than in the whole business value. Growth shares are flexible, tailored, and can ensure the existing value in the business is preserved for the original shareholders.
Growth shares are typically used by unlisted companies that don’t meet the conditions required to issue tax-advantage share options or for those companies that also want to offer incentives to non-employees – for example non-executive directors or consultants to the business. However, they can also be included as part of a tax-efficient Enterprise Management Incentive (EMI) scheme.
However, there are potential tax consequences of issuing growth shares, and either the receiving employee/beneficiary will need to pay market value or HMRC will require tax on the receipt of any growth shares at undervalue.
Before a business issues growth shares, it needs to establish the hurdle value – or in some structures even multiple hurdle values. The current value of the business is often key in determining this value. Once the company value is known and the hurdle value has been set, it is necessary to value the growth shares recognising the differential in class rights as compared against ordinary shares.
Valuations on issuing growth shares are therefore very different from, for example, valuing a business for sale, which will look to maximise overall company value.
For tax purposes, the growth share valuation is based around a hypothetical transaction between a willing seller and buyer using an appropriate amount of information. It will consider first the whole company value then the element attributable to the growth shares. This can involve complex calculations and modelling around the growth prospects of the business and the allocation of sale proceeds arising. It can be particularly challenging where forecasts are overly aspirational or not available.
It is important that when a company with growth shares is sold, there is a shareholders’ agreement setting out the process for the sale of, and the allocation of consideration to, the growth shares. It is also important to ensure that contemporaneous valuations are in place as these may be required by HMRC on the individual’s disposal of the growth shares or as part of purchaser due diligence.
GROWTH SHARES - AN EXAMPLE
Growth shares are perhaps best illustrated in the (fictitious) example of TopTech Ltd. TopTech was established by Janet and Chris ten years ago and now has a turnover of £10m. The business is projected to continue to grow further with Janet and Chris looking to hire several senior people and exit the business in five to eight years’ time via a sale to one of the global tech giants.
However, at present, TopTech is not able to pay top salaries for these new appointments, so they need to look at other ways to make the role attractive to the best talent. Janet and Chris also wish to ring fence the value they have already created in the business today.
Janet and Chris believe growth shares will give them the flexibility to incentivise new and existing members of staff to stay with the business, to help grow, and ultimately sell, TopTech by offering a share of future value growth, without devaluing their own hard work over the previous decade.
An added benefit of growth shares compared to ordinary shares is that any tax due by the employee on the receipt of growth shares would likely be significantly lower than for an equivalent percentage of ordinary shares, as the hurdle (the value beyond which the company must grow before holders are entitled to receive any value for their shares) devalues the shares.
However, the hurdle does not entirely devalue the growth shares as these have an upside only (i.e. there is no loss to the holder if there is a fall in company value).
If you would like further information on growth shares for employee motivation and retention,
get in touch with Tom Wacher:
Call: 0330 124 1399