Adoption of Appropriate Business Success Incentivisation Arrangements
for Workers
Involved In Early Stage / High Growth Businesses / Private Limited
Liability Companies
This dynamic note (i.e. intended to be developed over time) outlines
how arrangements can be devised (in the writer’s view) to deal with the
situation of how a fast growing business, as generally owned by a limited
liability company, can practically (and – hopefully - tax effectively) incentivise
workers engaged in the venture to actively contribute to the success of the
venture (by granting appropriate profit sharing and / or ownership rights in
the business).
The current coalition government in the U.K. has indicated
that it wishes to favour a ‘John Lewis Partnership’ model of encouraging business
success incentivisation for workers –
which many enlightened employers are also keen to see introduced into their
arrangements (provided arrangements can be devised which reasonably satisfy all
interested parties interests).
The writer hopes that the arrangements discussed in this
note can serve as a means for interested parties to consider, discuss and
settle arrangements ‘which work for them’.
The Rebirth of the
Partnership
Many early stage businesses rapidly incorporate as a limited
liability company – often before they have taken any professional advice (mainly
because this is quick and easy to do in the U.K. – being the traditional way to
provide for a limited liability ‘shield’ against business failure – and a limited
company provides relatively low level of tax upon retained / undrawn profits in
comparison with current individual income tax rates).
However if you go back in British business history far
enough (to a time when incorporation was not as cheap, quick and simple) – partnerships
were the habitual business model – e.g. ‘Scrooge and Marley’ (in fiction) – but
it is worth remembering that many current huge industrial enterprises were (in their
early years) traditional partnerships.
Many current private limited companies are de facto quasi-partnerships
of a small number of individuals.
If the circumstances of what the founder(s) / early stage
promoter(s) of the business are seeking to achieve in incentivising workers
towards business success match the model of a partnership – there can be
advantages to revising the existing business structure so that the limited
liability trading company involved can become owned wholly owned by a
partnership or by a limited liability partnership (LLP) – a legal entity which
has gained considerable popularity over the last decade.
The established trade (generally) continues within the
limited company and the partners can quickly and easily amend the ownership,
management and profit share interests in the underlying venture via adjusting the
interests in the partnership / LLP.
In the circumstance of a (say) two man quasi-partnership
company - which by reason of (say) its rapid growth needs to invite another
(say) two individuals into the ownership, management and profit share
arrangements - the formation of a new ‘top-‘partnership /
LLP is worth investigation.
Great care needs to be taken not to trigger tax charges upon
formation (upon which professional advice should be taken) and a carefully
drafted partnership or LLP agreement is highly advisable (but such document is
merely an alternative to a shareholders agreement – which the writer would
encourage all shareholders in a quasi-partnership company to have). In particular, partnerships / LLPs can be much
more effective in dealing with thorny issues arising from leavers (i.e.
previously active working shareholders who cease to be actively involved in the
business) and many issues relating to tax issues turning upon employment
related securities can be avoided.
“The Bonus
Backstop”
It should not be forgotten that the ‘John Lewis Partnership’
model (so lauded by many politicians) is but a glorified bonus scheme (operating
by the habitual declaration of an additional percentage payment calculated on the
basis of salary). Such a bonus is paid
through PAYE with income tax and employee national insurance payments deducted
at source (and with additional national Insurance payments required from the
employer).
In most (if not all) respects it is little different to the operation
of the derided ‘bankers bonus’ – and it should be noted that it is particularly
tax inefficient for the worker - and potentially creates an on-going expensive
liability that in practice is difficult to avoid (just ask the investment
banks!).
However, provided bonuses are clearly established as being
non-contractual; and they are not operated in an arbitrary (or discriminatory)
fashion – they can provide a useful incentivisation method (possibly in tandem
with other arrangements) with (at least theoretical) flexibility for the
employer to adjust overall remuneration.
The Favouring of
Capital Gains and Share Incentivisation
U.K. tax legislation highly favours the taxation treatment for
individuals of receiving the proceeds of capital gains as opposed to the
taxation of individuals’ income (currently at rate(s) up to 50%(+)).
Many fast-growing businesses wish to incentivise new joiners
and other staff, with an opportunity to share in the future success of the
businesses they join (in a tax efficient manner) – which aim has obvious
commercial drivers for the employer (including low up-front costs – allowing
growing businesses to potentially hire high calibre people whom they would not
otherwise be able to afford).
However, many new joiners and other staff are not in a
position to subscribe for new shares in the owning company at their full market
value at the time of joining etc. This generally means that they are unable to
acquire sufficient numbers of shares to give them a meaningful stake in any
increase in the value of the underlying business.
Any attempt to issue staff with shares at an undervalue (i.e.
‘gifts of free shares’) will give rise to an immediate charge to income tax on
the difference in value between the market value of the shares subscribed for
and the amount subscribed for them- under long-established provisions of U.K.
tax legislation seeking to tax such shares as remuneration for employment.
Over recent years, changes have occurred in the U.K.'s
capital gains tax legislation which broadly have had the effect of increasing the
general rates of capital gains tax applicable for individuals to 18%, or more
likely 28%.
However, an ‘Entrepreneurs relief’ from that CGT has
developed which currently effectively reduces the rate of capital gains tax applicable
to business assets disposed by certain qualifying individuals to 10% on the
first GBP £10 million of lifetime games, subject to satisfying a number of
qualifying conditions – the most important of which are that for twelve (12) months
prior to disposal, the individual held not less than 5% of the ordinary share capital
rights in the company (i.e. votes) and to be an officer or employed (full-time
or part time) during that period.
Accordingly, any arrangement which can legitimately utilise entrepreneurs
relief - can offer an extremely commercially effective and tax efficient share
incentivisation arrangement for (a) new joiner(s) to a fast-growing business.
Thankfully the 2012 Budget announced news of a proposed
extension of entrepreneurs relief (from capital gains tax) to the disposal of
shares acquired under particular option arrangements which were previously
extremely popular - such that the writer
is now favouring the following scheme for business success worker incentivisation
arrangements.
Enterprise
Management Incentive (EMI) Options
Because of their numerous advantages, the starting point
should be to establish whether it is possible for a company to grant EMI
options. If the conditions can be met the
tax treatment is very favourable:
·
No income tax on grant;
·
No income tax on exercise (unless the option was
granted at a discount to share market value and then only the amount of the
discount on grant is taxed on exercise); and
·
CGT on the sale of the plan shares.
In addition, a UK employing company will qualify for a
statutory corporation tax deduction equal to the gain on the exercise of the
option (i.e. market value on exercise less the exercise price).
The corporation tax deduction gives EMI the edge over any
other incentivisation arrangements.
If options are exercised on an exit, the deduction will
typically appear as a deferred tax asset in completion statements - and it is
often possible to persuade purchasers to give selling shareholders credit in
negotiations.
Options are easier to operate in that (generally no separate
class of shares is required and) leavers can be dealt with more easily by
allowing their options to lapse (thereby avoiding the need to put in place
arrangements to buy their shares).
To meet the conditions, companies must have:
·
gross assets of less than £30 million;
·
less than 250 full-time (or full-time
equivalent) employees;
·
be independent; and
·
satisfy certain other conditions.
While care should be taken – Most private companies can
qualify with ease..
There is an individual limit (relatively recently increased)
of GBP £250,000 worth of shares which may be subject to unexercised EMI options.
Participants must be employees within the group and must
work at least 25 hours per week (or 75% of their working time, if less).
There are various other conditions (e.g. reporting, type of
shares which may be used etc.) but listed companies are likely to meet these.
Growth shares
If the EMI conditions cannot be met (or the limits are
exceeded) an alternative the writer often favours is to create a new class of
shares which only participate on an exit on gains in excess of market value on
the date of acquisition.
If performance conditions are required, these can be built
into the articles thereby further reducing the up front value of the
shares.
Employees subscribe for the shares – generally at no more
than par (so the initial cash employees are required to fund is not too onerous)
and provided certain ‘hoops are leapt through’ – any gains in value thereafter
are taxed as capital gains.
Suggested Possible
Solution – ‘New Joiner(s) Receiving Growth Shares Under EMI Options
The arrangement that the writer suggest is explored further
in relation to private companies is an arrangement sought to be explained below
(as also represented in the table set out in the schedule to this paper).
The arrangement works by creating a new designated class of
shares at any point at which (a) new joiner(s) is / are invited to participate
in the shareholding of the relevant company.
At each point at which (a) new joiner(s) is to ‘join the
company’, a settled market valuation of the company is arrived at - and that
value is ‘embedded’ in the class rights of the existing shares at that point in
time (in settled proportions).
The new joiner(s) is / are then granted an EMI option over a
proportion of a fresh class of shares with a designation which entitles them to
(an) agreed right(s) to any increase in the overall value of the company - over
and above the settled value of the company at the point at which the option is
granted.
Such a mechanism can be repeated across subsequent round(s)
of new joiner(s) joining the business. At each point at which new options are
granted, the new joiner(s) are only granted a share option right to a pre-agreed
proportion of any possible increase in value of the overall company - and at
the point at which the options are granted, they (highly arguably) have a value
of little more than their nominal (par) / (relatively) negligible value.
The eventual hoped-for position of all interested parties is
that upon a crystallisation of value in the shares of the company (i.e. by way
of a share sale, a liquidation following disposal of the business - or even a
flotation) the respective classes of shares receive a sum of value (hopefully
in cash) reflecting their proportion of the particular bands of value ‘embedded’
within their share class over time and the shareholders thereby divide up their
returns in pre-agreed proportions. Consideration of the table below may well assist
in understanding the mechanism further.
It is also necessary to discuss and agree the voting rights
and the dividend rights which might apply to each of the particular share
classes.
It is (seemingly) easier to agree (and arguably fair) that shares
should vote in proportion to their capital rights in the highest ‘value band’ (with perhaps - the founder
shares have certain veto rights)and in relation to dividends, there being
agreement (say) that dividends only be paid with all appropriate agreed parties
consent and then paid in accordance with the proportionate holding of blended
capital rights in the company at the point at which the dividend is paid – (effectively
meaning that new joiner(s) initially have no dividend rights but that hopefully
dividend rights accruing to them over time as the overall value of the company
increases).
N.B. - This note has
been prepared for various interested parties to consider how such a scheme
might work in practice - and then discuss how they might wish to structure the detail
of such an arrangement. There are a number
of potential commercial and taxation pitfalls with such an arrangement - which
should only be implemented by professional advisers who are extremely familiar
with this particular method of share incentivisation.
Without limiting the generality of the previous statements,
appropriate articles of association (and a shareholder's agreement) dealing
with how the quasi-partnership might operate in the future and deal with
certain situations, circumstances and issues which might arise - are advisable
to be adopted. This firm / I would be
delighted to discuss matters further with you and work with you to implement
such an arrangement.
The Schedule – Table Seeking to Explain Arrangement
N.B. – Figures shown
are example figures only.
|
|
Founder 1
|
Founder 2
|
New Joiner 1
|
New Joiner 2
|
Total
|
|
Capital rights in current value of Company at the point New Joiner(s)
1 join the Company (£ x).
|
[50%]
|
[50%]
|
-
|
-
|
100%
|
|
Capital rights in any gain in excess of the then current value (£ x)
in the ‘band of value’ created until New Joiner(s) 2 join the Company (£ y).
|
[40%]
|
[40%]
|
[20%]
|
-
|
100%
|
|
Capital rights in any gain in excess of then current value (£ y) in
‘band of value’ created until any further ‘new joiner event’ or sale / IPO /
other ‘realisation event’.
|
[36%]
|
[36%]
|
[18%]
|
[10%]
|
100%
|
|
Suggested Share Designations
|
‘(Founder) Ords.’
|
‘(Founder) Ords.’
|
‘A Ords.’
|
‘B Ords.’
|
Etc.
|
M. (+44) 07788 537 187 (U.K. Cellular Telephone)
E. DanielRobertJohnson@gmail.com
