Employee incentives and share schemes are a key mechanism for PE to retain and reward their management teams as well as helping to focus PE and management towards a common goal.
The management team of any investee business is key to its success. Employee incentives and share schemes have the following main benefits for PE and the management team:
- Rewards good performance and behaviour.
- Focus the rewards for detailed specific performance (e.g. sales directors rewarded for sales and CTO rewarded for delivery of projects).
- Retain management, If management leave employment they forfeit their incentives.
- Align management and PE's vision for the success of the business.
- Provide tax efficient reward and incentives.
The reward can be structured in different ways. It is common that it is linked to a future sale of the business. Whilst each approach has its advantages, there are also specific tax factors to consider. Details of the different type of share schemes and incentives are set out in flyer from our website at DWF Share Schemes Flyer December 2024 (3).pdf
We have set out below a brief summary of the main incentives that are available and regularly used by PE to recruit, retain and reward their management teams.
Share options
Share options allow employees to acquire shares at a fixed price at some point in the future once the options have vested. The exercise of the share options can be conditional on either the expiration of a period of time or performance milestones. On exercise of the option the employee would acquire the shares. If structured correctly the management team can make a capital gain, subject to capital gains tax ("CGT") currently at preferential rates to income tax and National Insurance contributions ("NICs").
The value of a share option is it a relatively simple incentive that does not require the issue of shares until immediately before an exit event. If the employee leaves the business the option would lapse. The Company does not have to recover any shares from a departing employee.
The two main tax advantaged share options are Enterprise Management Incentive ("EMI") and Company Share Option Plan shares ("CSOPs").
EMI share schemes
For EMI share options, there is no income tax or NICs liability when the options are granted, or when they are exercised by the option holder (provided the exercise price is equal to the market value of the hares at the date of grant).). The option holders would be subject to CGT on any gain in value of the shares from the market value of the shares at the date of grant. The exercise price can be set at below market value at the date of grant. If this is utilised the option holder would be subject to income tax and NICs at the date of exercise on the difference between the exercise price and the lower of the market value of the shares at (i) the date of grant; or (ii) the date of exercise.
These share schemes are only available to certain qualifying companies. To qualify, a company must meet certain conditions. These conditions include carrying on a qualifying trade, having assets of £30 million or less and fewer than 250 full-time employees. The option holder must also be a qualifying employee. They must work at least 25 hours per week or 75% of their working time for the group.
This is the most tax efficient and flexible approved arrangement available, although limits the availability to smaller businesses.
Company share option plan schemes
CSOPs are generally used when a company does not qualify for EMI. To benefit from the tax relief from a CSOP, the share options must be held for three years, before being exercised. There are certain exceptions to the three-year rule, such as a sale within the three-year period. This incentivises employees to remain with the business long enough to obtain the shares and the associated tax benefit.
Unlike EMI the exercise price must be equal to the market value of the shares at the date of grant. Upon exercise, the employee will not incur an income tax liability on the difference between what the shares are worth and the market value at the date of grant. They may still have to pay CGT on any profit when they sell the shares.
Unlike the EMI scheme, CSOPs are not restricted by company size. They are however restricted by the value per employee as each employee can only be granted an option over up to £60,000 worth of shares.
Growth shares
Where tax approved incentives are not available, there are other unapproved incentives, which seek to obtain the same tax advantage as the above-mentioned tax approved schemes.
A growth share incentivises employees by providing them the opportunity to benefit from future increases in company value. Employees are issued with shares rather than share options. The benefits of owning these shares cannot be achieved until there is a sale of the shares for a value over a pre agreed "hurdle". The aim is for the growth shares to be acquired by employees when the market value of the shares is low value to minimise any upfront cost or tax liability.
If the hurdle is exceeded on a sale the employees would sell their growth shares for their value. The employees will not incur any income tax provided the shares were purchased at market value. The employees will be liable for CGT on the increase in value of the growth shares,
Unlike EMI or CSOP schemes, these incentives are not restricted to company size and can also be issued to non-employees. This is a useful incentive for companies that have already exceeded the size to qualify for EMI options.
Nil paid or partly paid shares
If the company wishes the employees to benefit from the full value of the company and not an amount in excess of a hurdle, the company could issue shares to the employees nil or partly paid. There would be an obligation on the employee to pay the amount unpaid on the shares when the company calls for payment, such as on cessation of employment or an exit event.
The nil or partly paid shares mitigates the requirement of the employee to either pay the market value of the shares at the date of issue or income tax (and potentially NICs) on the market value of the shares at the date of issue of the shares.
The aim of nil or partly paid shares is to obtain the same tax treatment as approved share schemes. The employee does not have an income tax or NICs liability on acquisition of the shares. The employee pays CGT on the increase in value of the shares above the market value of the shares at the date of issue to the sale price.
Issuing shares to employees
The slight disadvantage of issuing shares directly to employees is if the employee leaves the group the shares must be bought back from the employee. Mandatory transfer arrangements can deal with this concern. The other downside for UK companies is that the employees can see how many shares each employee holds. This can be mitigated by arranging for an Employee Benefit Trust to hold the legal title in the shares, with the employee holding the beneficial interest in the shares.
Employee benefit trust (EBT)
An EBT is a discretionary trust that holds its assets on behalf of current and former employees and their dependents. The EBT can hold the legal title in the shares and be seen as the owner of the shares in the register of members or Companies House. The employee would hold the beneficial interest and all economic rights in the shares. An EBT also has the added security that on cessation of employment of an employee the EBT already holds the legal title in the shares and the company only must recover the beneficial interest from the departing employee.
