Using equity is a tried and tested method to help recruit, retain and incentivise key employees and align their interests with shareholders. One commonly used structure involves 'growth shares'.
What are growth shares?
Growth shares are a special class of share which allow employees to benefit from the company's growth above a predetermined valuation 'hurdle'. Essentially, growth shares reward individuals for the value added to the company after they acquire the shares.
How do they operate?
The best way to understand how growth shares operate is by way of an example:
Company X has a value of £9,000,000. Growth shares are issued with a valuation hurdle of £10,000,000. Employee A subscribes for 10% of the issued share capital in the form of growth shares which only serve to benefit if the company reaches its target value of £10 million. The market value for the growth shares is relatively modest and this is no higher than the price paid by the individual.
Two years later, the company value has increased, and it is sold for £12,000,000. The first £10,000,000 (the hurdle) goes to pre-existing shareholders and the remaining £2,000,000 is shared between those shareholders and Employee A as a holder of growth shares. Their 10% stake entitles them to £200,000 in consideration.
This is just one simple example to help illustrate the concept, but there is a lot of flexibility available in designing a growth share arrangement and ensuring it fits in with your existing share capital structure. We have experience of assisting clients with all manner of different formulations of growth share arrangements.
What benefits do they have?
Growth shares are advantageous for several reasons.
As with all share plans, the interests of employees are aligned with those of shareholders, as their compensation is tied to the future success of the company. This is even more important with growth shares because employees only participate once the company's value surpasses a certain level, making the company's value of the utmost importance to them – they are rewarded for the value they help create.
One of the key benefits of growth shares, which is not always apparent in other share types, is that they do not dilute other shareholders' economic interests until the value of the company increases past a set threshold. This helps preserve the company's value for its original shareholders/founders.
Another advantage of growth shares is their affordability. As these shares do not have any significant value until the business meets its value 'hurdle' (and there is a possibility it never will), the market value for tax purposes is relatively affordable, allowing participants to pay this at the outset, acquire the shares, and not have an upfront income tax liability. Once the employees hold the growth shares they are typically taxed as any other shareholder in the form of capital gains rather than income i.e. in a tax efficient manner.
Who is eligible for growth shares?
Unlike other statutory tax advantaged share schemes, such as Enterprise Management Incentive options, growth shares are not subject to restrictions on company size, assets, and the number of employees. More than this, growth shares can be issued to non-employees such as consultants, directors, freelancers, and contractors. The company can decide who takes part at their discretion, making growth shares one of the most flexible options available.
In conclusion, growth shares are an excellent way to retain and reward individuals and align their interests with those of shareholders. While they require a new class of share to be established within the company, they are flexible and can deliver tax advantages to individuals and the company alike.
This article was co-authored by Trainee Taylor Foster.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
