Growth Shares are a special class of shares which reward holders with the growth in value of the company above a ‘hurdle’ which is specified on issue. Growth Shares generally allow gains to be taxed as capital by holders and could be used when EMI cannot be used.
Acquisition of ordinary shares, rather than Growth Shares, are usually not attractive since that will involve up-front cash costs. In addition, if market value is not paid by the employee for the ordinary shares, an income tax charge (and possibly social security charges depending on the circumstances) on the difference between the market value of the shares and the amount will require to be paid.
The arrangement could instead be structured using Growth Shares as follows:
The articles of the company are amended to create a new class of Growth Shares of 1p each with no rights other than to participate in sale proceeds on an exit (or distributions on a winding-up) pro rata with ordinary shares but only after ordinary shares have received the specified hurdle amount per share.
The employee enters into a subscription agreement which requires them to pay 1p per Growth Share according to a vesting schedule.
The subscription agreement provides the company a right to purchase unvested Growth Shares for 1p each if they leave for any reason and a right to purchase vested Growth Shares at fair value (or 1p should the employee resign, be dismissed for cause or breach non-compete obligations post-cessation).
The employee undertakes to pay income tax on the ‘unrestricted market value’ of the Growth Shares (which is, broadly, the value of the shares for tax purposes ignoring the vesting and forfeiture conditions) within 14 days of acquisition.
The company takes professional valuation advice which values it at say £1 million with 100,000 ordinary shares in issue. In such a case, the up-front value of the Growth Shares with a hurdle of £10 could be considered as no more than par.
The employee declares the receipt of Growth Shares in his tax return and his tax inspector accepts the Growth Shares have a market value of no greater than their nominal value (1p per share) so there is no income tax to pay as a result of making the election as the employee paid market value for the shares.
Three years later the company is sold for £10 million. There are 100,000 ordinary shares in issue and 3,000 Growth Shares held by the employee. The first £1 million of sale consideration is paid to the holders of ordinary shares and the remaining £9 million is paid pro rata to holders of ordinary shares and Growth Shares. The employee receives £9 million / 103,000 = £87.38 per Growth Share or £262,136 in total. All gains are taxed as capital at the top rate of 20% so he pays capital gains tax of £52,427 ignoring annual exemptions.
Note: This example assumes HMRC will agree the unrestricted market value by deducting the hurdle from the value of ordinary shares. Some inspectors, however, take the view that Growth Shares have a hope value over and above the intrinsic value when compared to ordinary shares. If so it may be necessary to agree the Growth Share have a higher value (resulting in some up front tax charge).
Some additional features
Different hurdles can be set each time Growth Shares are issued. Putting the vesting and leaver provisions in the subscription agreement, rather than in the articles, means these arrangements remain private and can be different for each holder if required.
The subscription agreement often contains a power of attorney which appoints the founder of company as attorney on behalf of the holders to sell the Growth Shares to a third party purchaser upon an exit being achieved.
The legal title to the Growth Shares can be held by a nominee to keep the identity of the holder private, if necessary.
It may be possible to structure the Growth Shares so holders qualify for entrepreneurs' relief so that capital gains will be taxed at a fixed rate of 10% (up to a lifetime limit of £10 million). The key conditions being in the 12 months prior to disposal:
the company must be a trading company or the holding company of a trading group;
the individual must have been an employee or office-holder; and
the company must be the individual's ‘personal company’ (being a company in which the individual holds at least 5% of the ordinary share capital when tested by nominal value and 5% of the voting rights).
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