Change is brewing – using equity to incentivise employees

The firm’s founder James Watt will transfer a fifth of his stake in the company into an employee benefit trust, allowing around 750 of its employees to participate in the future success of the company. 

Of course, the same business rationale will apply to many companies operating within the tech sector and in this article, we consider various options businesses can take to incentivise their employees with equity.

Enterprise Management Incentive (EMI) Options

This is a government-backed scheme aimed at small-to-medium-sized businesses to give their employees the opportunity to receive an equity stake in the company immediately prior to its sale. 

Whilst there are certain qualifying criteria required for both the company and the employee (notably in respect of company asset values and employee working hours – please see here for further details), this is tax-advantageous for employees  and normally results in a lower rate of capital gains tax and zero national insurance or income tax liabilities on the condition that the option shares are ultimately bought at a price at least equal to their market value on the date that the employee was granted the option.  It also gives the participating employees a chance to make a significant profit upon the sale of the company.

Generally, this scheme is put in place by way of a set of scheme rules, which set out when and how an employee can exercise their EMI options, which shares they will acquire upon the exercise of their options and the rights associated with those shares.  Generally, EMI options are ‘exit only’, meaning that they can only be exercised immediately prior to an exit event, for example, a sale of the company’s entire issued share capital or the company listing on a public market.  The employee then pays the company an agreed market value price for the shares (often agreed with HMRC in advance of the grant) and the shares are then, ideally, sold by the employee for a profit.  

For this to take effect, a set of scheme rules referred to above, amendments to the company’s articles of association and other ancillary documentation (shareholder and board resolutions and share certificates) are required.  HMRC must also be notified within 92 days after the grant of any options to ensure that the participating employees can secure the relevant tax relief.

Unapproved share options

If a company wishes to grant share options to employees in a similar way described above but is ineligible due to its size or the nature of its business, it can follow the same process but without the employee tax benefits or additional reporting requirements.

Similarly, a set of scheme rules (where the company can be more flexible due to unapproved options not being part of the same regulatory framework as the EMI options), amendments to the company’s articles of association and other ancillary documentation will be required for this to take effect. 

Save as you earn (SAYE)

This scheme is often preferable for employees as it is low-risk. 

In practice, the company offers employees a discounted share price (up to 20% below its market value at the date of the offer).  If an employee chooses to participate, the company then deducts a cash amount up to £500 from each participant’s monthly earnings.  The participant can decide the amount that they wish to have deducted.  After the fixed period (normally three or five years) ends, participants who are still employees of the offering company have the right to use their accumulated savings to acquire shares based on the initial discounted price offered at the date of grant.  If the share price is significantly higher, an employee would generally exercise their option to acquire the shares at a preferential price, resulting in them owning shares valued in excess of what they have paid.  If the share price is the same or lower, an employee would usually consider simply ‘cashing in’ their accumulated savings rather than acquiring the shares.  The company would then return the accumulated savings to the employee with no deductions.  

A benefit of this scheme is that there a tax saving for employees in most cases, as selling these shares should not incur income tax or national insurance tax.  Capital gains tax is likely to apply on any gain when sold, however.

Given that the future sale of shares and a determined share value is less certain for a private company, this scheme is generally used by larger listed companies.  

Growth shares

These differ from share options in that the shares are issued by the company to employees at the same time of the grant rather that granting just an option to acquire shares in the future.  Generally, the shares issued to employees here are a class of non-voting shares with a low market value and rights to a capital return only arise if the exit value exceeds a certain figure.  This figure or ‘hurdle’ can be set by the majority shareholders and is often at the higher end of the estimated exit value.

This incentivises employees to make the business as profitable as possible so that they can receive the benefit of a higher-value exit.  As above, amendments to the company’s articles of association and other ancillary documentation will be required here.

Employee benefit trusts

This approach has reportedly been used by Brew Dog’s James Watt.  It is commonly used as a vehicle to acquire and warehouse certain shares without employees actually paying for them or owning them.  The employees will be beneficiaries of the trust although the trust will normally be operated by an independent professional trustee.  This has various tax advantages and requires a comprehensive trust deed along with amended articles of association and the usual ancillary documents in order to have effect.

Employee ownership trusts (EOT)

These are trusts set up to allow employees to acquire the entire issued share capital of a company when the existing shareholders wish to sell.  The trusts are usually operated by an independent professional trustee but with the employees being the beneficiaries.

In practice, the company will, via the EOT, pay the purchase price to the vendors in tranches based on the agreed value attributed to the company (normally valued by an independent accountant) prior to the deal.  The company will then generate trading profits each year to pay to the EOT, who will in turn use these profits to satisfy payment of the purchase price to the departing sellers. 

This approach is beneficial for the outgoing sellers of the company as they generally do not incur any capital gains tax liabilities.  It is also seen as a ‘friendlier’ way of selling the business, with the documentation often being shorter and less negotiated, resulting in lower professional fees.  

This is slightly different to the aforementioned incentives as it generally concerns the sale of the entire issued share capital of a company rather than issuing a minority stake.  Therefore, a share purchase agreement will be required along with a trust deed and the relevant ancillary documentation.  There may also be elements of due diligence and a disclosure exercise required here.  This approach is becoming increasingly popular as it offers a strong succession plan to the outgoing sellers.

Conclusion

The above list covers only a few of the ways in which employees can be incentivised by their employers other than providing increased remuneration packages.  Given the recent strain on many businesses and rising living costs for employees, these alternative solutions are likely to increase employee loyalty without the financial implications of increasing salaries.

Whilst many of these options are driven from a tax perspective – and therefore would require input from a tax adviser before proceeding - putting the relevant legal documentation in place to do so is vital to ensure that the company and its majority shareholders are protected and that the proposed scheme is compliant with the relevant statutory framework.  Boyes Turner’s Corporate team would be pleased to discuss any of the above options with business owners looking to explore alternative employee incentive schemes.