Incentivising your key employees

Insight

21.10.2024

Most start-ups and growing businesses are tight on cash, but that doesn’t mean they cannot attract high calibre employees. The potential to realise a significant lump sum can persuade people to join and encourage them to stay. All you need is an incentive plan. But which one?

The entrepreneur faces a myriad of questions when making this choice. Is it better to award shares, share options, or cash? If employees are to become shareholders, should they enjoy the same share rights as founder members? When is the best time to put an incentive plan in place? What approvals does the company need?

A useful first step is to consider some key issues:

Control: Some companies prefer not to give employees shares at the outset, or at all, because they wish to avoid the need to accommodate the interests of minority shareholders. There is also the added complication of retrieving shares from employees who leave.

Decide if you are prepared to have minority shareholders and whether a departing employee should relinquish their shares.

Reward: Share options can provide employees with a more effective incentive than awarding shares upfront because they can be designed to be exercisable only once the company achieves set targets, or when the company is sold or listed.

Review your business plan. Is the intention to pass ownership to the next generation or to work towards an “exit”?

Tax: Certain incentive plans that benefit from tax approved status are tax efficient. If the required conditions are met these “schemes” are likely to be best.

Check whether the size of your company and the nature of its trade will qualify the company for a tax advantaged scheme.

Timing: The longer a business is established, the more likely it is that the shares have more than just “hope value”. Affordable shares will be an attractive incentive to participants.

Consider whether the incentive plan can be implemented now, or whether it would be wise to wait until the management team is more established.

The range of incentive plans is broad. Below, we outline the more popular plans available to small and medium-sized unlisted companies and discuss the tax treatment of each.

Share options

Tax advantaged share option schemes

The basic tax advantage of these schemes is that when the shares under option increase in value, the gain is taxed at the more attractive capital gains tax rates, rather than being subject to the higher income tax rates. Further, the tax charge is only triggered when the shares are sold or gifted.

Enterprise Management Incentive options

An Enterprise Management Incentive (EMI) scheme is the most attractive scheme for small and medium-sized companies. Under an EMI scheme the company grants an employee, including a director, a right to buy shares in the company. The exercise price of an EMI option can be set at any level (and can be nil, if option shares are not newly issued). However, if the exercise price is less than market value at grant this has consequences for the tax treatment of the EMI option. The expectation is that by the time the options are exercised, the shares have risen in value, and the employee will receive the shares at a discount.

A company can grant EMI options of up to a maximum share value of £250,000 per employee, and up to £3 million in total. The company must self-certify that its EMI scheme meets the statutory requirements and specific registrations, notifications and annual returns must be made.

Which companies can grant EMI options and to whom?

A company is qualified to grant EMI options if it:
Is not a subsidiary of another company,
Is based in the UK,
Has gross assets of no more than £30m,
Has fewer than 250 employees, and
Is engaged in a “qualifying trade”.

Non-qualifying trades include: investing in land, shares or financial instruments, certain financial services, leasing assets, receiving licence or royalty fees, legal/accountancy services, property development, farming or forestry.

The company will have discretion to decide which employees should have options, but the chosen employees must work full-time for the company. A full-time worker is someone who works for the company at least 25 hours per week or for at least 75 per cent of their paid working time. So, EMI options cannot be granted to non-executive directors or individuals providing their services through a company. Employees (together with their connected persons) may not hold more than 30 per cent of the company’s shares.
The shares under option must be part of the ordinary share capital of the qualifying company, fully paid up and not redeemable, however they can be a separate class of shares, with or without voting rights. EMI options can be made subject to conditions for vesting (eg performance metrics of the company), but the options must be capable of being exercised within 10 years.

Tax treatment of EMI options

There is no income tax liability on the grant of an EMI option.
Provided the exercise price is at least the market value of the shares at the date of grant, there will also be no income tax charge at the time the EMI option is exercised and the shares are acquired. In most cases the market value will be discounted to reflect the minority shareholding that the options relate to. Usually, the share value is agreed with HM Revenue and Customs before the options are granted so as to provide certainty. If the exercise price is less than the market value of the shares at grant, then on exercise income tax will be due on the difference between the exercise price and the market value at grant.
When the shares are eventually sold by the employee, they will be liable to capital gains tax on any gain realised over the market value at grant. If the disposal qualifies for Business Asset Disposal Relief (BADR) the tax rate will be 10 per cent. For BADR the date of the option grant will need to pre-date the sale of the shares by a minimum of two years, and there is no 5 per cent shareholding requirement. Each taxpayer has a lifetime limit of £1 million which can be taxed at the BADR rate.
In most cases there will be no national insurance contributions (NICs) to pay if no income tax is due, but there will be NICs if income tax is payable and the shares are “readily convertible assets” (which broadly means that a market for the shares already exists). The employer and the employee may agree for the employer NICs liability to be borne by the employee who may get tax relief for doing so.
The EMI option holder’s employer can claim tax relief equal to the gain the employee makes when the options are exercised.

Company Share Option Plan

The company share option plan (CSOP) is a tax-advantaged discretionary share plan which may be used by companies which do not qualify to grant EMI options eg because they are too big or aren’t engaged in a qualifying trade. However, there is less flexibility with a CSOP compared to an EMI scheme. In particular, the exercise price must not be less than the market value of the shares on the date of grant and the beneficial tax treatment generally requires the option to be exercised only after three years.

A company can grant CSOP options of up to a maximum share value of £60,000 per employee. The company must self-certify that its CSOP meets the statutory requirements and specific registrations, notifications and annual returns must be made.

Which companies can grant CSOP options and to whom?

The company whose shares are placed under option must be either listed on a recognised stock exchange or not under the control of another company.
The options can be granted either by the employer or a parent company (but CSOP options cannot be granted over shares in an unlisted subsidiary of a listed company).
As with an EMI scheme the company has discretion to decide which employees should have options, however the option holder must either be an employee or if a director must work full time for the company. Option holders (together with their connected persons) may not hold more than 30 per cent of the company’s shares.
The shares under option must be part of the ordinary share capital of the qualifying company, fully paid up and not redeemable. As with EMI schemes the CSOP rules now permit the option shares to be a separate class of shares, with or without voting rights, and so this can include growth shares. CSOP options can be made subject to conditions for vesting (eg performance metrics of the company), but the options must be capable of being exercised within 10 years.

Tax treatment of CSOP options

There is no income tax liability on the grant of a CSOP option as the exercise price must be at least the market value of the shares at the date of grant.
There will also be no income tax charge at the time the CSOP option is exercised provided exercise takes place at least three years from grant. However, in some cases there is no income tax liability on exercise within three years of grant, such as where the option holder has left employment due to disability, injury, redundancy, retirement, a sale of the employer or a change in control.
If there is a liability to income tax, the option holder will be chargeable to income tax on the difference between the market value of the shares acquired and the option exercise price.
When the shares are eventually sold by the employee, they will be liable to capital gains tax on any gain realised over the exercise price. BADR may be available provided the conditions are met. In particular, the shares must have been owned for two years and a 5 per cent shareholding is required.
In most cases there will be no national insurance contributions (NICs) to pay if no income tax is due, but there will be NICs if income tax is payable and the shares are “readily convertible assets”. The employer and the employee may agree for the employer NICs liability to be borne by the employee who may get tax relief for doing so.
The CSOP option holder’s employer can claim tax relief equal to the gain the employee makes when the options are exercised.

Unapproved share options

For companies which are not eligible for a tax advantaged scheme, share options are still a cost-efficient and flexible incentive to offer employees. These options are referred to as “unapproved options” and they can also be awarded to both employees and non-employees, eg consultants.

Tax treatment of unapproved options granted to employees

There is no income tax liability on the grant of an unapproved option to an employee.
On exercise of an unapproved option, the employee must pay income tax on the market value of the shares less the exercise price paid. If the shares are readily convertible assets (see above), this income tax will be collected under Pay As You Earn (PAYE) and NICs will also be due.
The amount on which tax is paid is added to the employee's acquisition cost of the shares for capital gains tax purposes when the shares are sold. BADR may be available (see above) if the conditions are met, but here the shares themselves must have been owned for at least two years and there is a minimum 5 per cent shareholding requirement.

Tax treatment of unapproved share options granted to consultants

A consultant can receive options in return for consultancy services provided to the company.
The tax effect of granting share options on this basis is generally understood to be that an income tax charge arises on the value of the option at grant based on the market value of the shares at that time.
There is no income tax charge on exercise and any growth in value thereafter should be chargeable to capital gains tax. BADR would not normally be available.

Share plans

Nil paid shares or partly-paid shares

Where an immediate share award is desired, but the intended recipient does not have sufficient funds to pay full value for their shares, the company can defer payment and issue or transfer the shares as “nil paid” or paid-up as to part. The amount owing on the shares will be a debt which must eventually be settled by the recipient. The recipient will bear the risk that the share value may fall below the price they are obliged to pay.

Tax treatment of nil paid/partly paid shares

At the time of issue there would be no income tax or national insurance contributions provided the shares are purchased for market value.
A sale of the shares will be subject to capital gains tax on any increase in value. Provided the conditions are met, including the minimum two-year holding period and depending on the share rights afforded to the nil paid shares, BADR may be available.
If the unpaid amount is not subject to an interest charge, a shareholder who is an employee may be liable to an annual tax charge based on the outstanding amount. If the amount owing is ever waived then an employment income tax charge and NICs will arise on that amount.

Growth shares

Growth shares are designed to reward participants for the growth in value of the company above a “threshold” or “hurdle” which is specified on issue. Only once the hurdle is met do the shares have value. Growth shares are popular with companies which do not meet the conditions for tax-advantage share schemes or who wish to offer incentives to non-employees such as consultants and non-executive directors.

Tax treatment of growth shares

Growth shares should not trigger an income tax charge on issue if the value of the shares at issue is robustly established and paid up (or agreed to be paid up).
The increase in value of a growth share would be subject to capital gains tax on disposal of the shares. BADR may be available provided the conditions are met and the growth shares have sufficient value to entitle the holder to 5 per cent of the proceeds on sale.

Growth shares should be introduced with caution if the company has existing shareholders who acquired their shares under the Enterprise Incentive Scheme (EIS). There are circumstances when an issue of such shares can cancel the tax breaks afforded to the EIS shareholders.

Bonus plans

Phantom equity

A phantom share option plan is a cash bonus plan under which the amount of the bonus is determined by reference to the increase in value of the shares subject to the option. No shares are actually issued or transferred to the option-holder on the exercise of the phantom share option.

Tax treatment of phantom equity

No income tax is payable on the grant of a phantom share option. When the bonus is paid it will be subject to income tax and national insurance contributions in the same way as salary payments.

Deferred share bonus plan

Under a deferred share bonus plan all or part of the employee's bonus is delivered in shares. Receipt is usually deferred and made contingent on the recipient remaining in employment until the end of the deferral period.

Tax treatment of a deferred share bonus

The share award will be subject to income tax at the time the shares are issued. National Insurance Contributions will be due if the shares are ‘readily convertible assets’ (ie marketable) at that time.
A subsequent disposal of the shares will be subject to capital gains tax. BADR may be available provided the conditions are met.

Need advice?

Farrer & Co can help you to choose an incentive plan and tailor it to your business. We can implement the plan, register it with HM Revenue and Customs (as required) and explain to all the participants how it works.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.