Small to medium-sized business owners know the importance of incentivising and retaining key employees using a share options scheme.
They’re both tax efficient for the company and the employees who benefit.
However, there are practical problems which mean that such schemes may not work. If this happens, the company and employees may find that the tax incentives which led them to implement the scheme are not available or that the scheme did not achieve its desired outcome.
Enterprise Management Incentive
The most common scheme is the Enterprise Management Incentive (EMI) scheme. Typically, once a young business becomes established, the company will offer key employees share options under the EMI scheme. Commonly, employees are only allowed to exercise the option when the company is sold and therefore receive the value without accruing any rights as shareholders. This allows the employees to participate in the sale at no direct cost to the company or its founders.
How the EMI works
Implemented properly, the scheme allows the employees to pay capital rather than income tax on the proceeds of sale of shares after exercising the option. Employees may also able to claim entrepreneur’s relief, which further reduces the capital tax payable. The company can also claim a corporation tax deduction for the cost of implementing the scheme and the excess of market value of the shares at exercise of the option over the amount paid for them by the employee.
Is an EMI right for every employee?
An option scheme exercisable on sale only incentivises employees who have bought into that outcome. The business may need to look at other incentives for other equally important employees who have not bought into a sale. These can range from bonuses to other share option schemes. Alternatively, EMI options may be expressed to be exercisable after a number of years.
If the key people are not employees, i.e. self-employed, work less than 25 hours a week or 75pc of their working time at the company, they cannot benefit from an EMI scheme and other schemes can be considered.
If the company is ineligible for an EMI scheme then it may use another tax-advantaged scheme such as a company share option plan (CSOP), which has a similar taxation profile as EMI, or a Save As You Earn (SAYE) scheme or a share incentive plan (SIP), which are structurally very different.
Any employee who on exercise will own more than 30pc of the company will not enjoy the full tax benefits.
Can the company do this?
The articles of association and any shareholders’ agreement need to be checked to see if they allow for adopting a scheme or if they should be amended. For example, shareholder approval may be required to grant options or allot shares on exercise of the options. Older companies will have to check if the authorised share capital needs to be lifted to allow for allotment of shares once the option is exercised.
What is not allowed
There are various statutory requirements which contain common stumbling blocks:
- The company or group cannot have a turnover of more than £30m and it must have fewer than 250 full-time employees.
- The company must be independent. This means it must not be a 51pc subsidiary of another company or under “control” of another company. Any subsidiaries the company has must be at least 51pc owned by the company.
- The company must also be either trading, carrying out a “qualifying trade”, or be the parent company of a trading group. In this context, “non-qualifying” trades include dealing in land, financial trading, receiving royalties, leasing, property development, hotel management, and similar high-end asset-backed businesses. Other restrictions also apply depending upon the activities of the business.
7 things to consider
The company must introduce rules so all know how the scheme works. The company will have to consider:
- When the option can be exercised – i.e. after a number of years or when the company is to be sold
- Conditions of exercising the option by the employee
- If there is to be a long-stop date when the option becomes void
- When the option should lapse if the employee ceases employment – these are akin to good and bad leaver provisions
- Consequences of the company undergoing a reorganisation
- Existing shareholder protections
- Protecting the company in relation to tax and national insurance contributions (NICs), if any liability arises
The exercise price of EMI share options can be set at any level but setting an exercise price that is less than market value at grant of the option (i.e. a discount) will mean that income tax, and possibly NICs, will be paid on that discount.
You need to get HMRC approval
A valuation should generally be sought to determine the tax treatment on exercise and to manage the £3m total limit of EMI options and the EMI individual limit (currently £250,000) that can be held by an employee. It is advisable to then agree the market value of the shares with HMRC Shares and Assets Valuation, especially if the option is “exit only”. An accountant should be instructed to deal with this. HMRC will approve valuations but this approval will not stop HMRC from subsequently questioning the valuation. The approval reduces the risk of this happening.
The company valuation is crucial to the scheme. If the valuation is low, then the price the employees must pay on exercise will be less and the taxation on the gain they make will be greater. A higher valuation may not incentivise and render the scheme pointless
EMI share options schemes can be invaluable for unlocking a company’s potential and giving those working for the company a lucrative exit. However, one size does not fit all. Not every company will find that the EMI scheme is appropriate. It is better practice to look at the outcomes the company wants, analysis of which will determine the correct scheme.
George de Stacpoole is a corporate solicitor at Seddons
A guide to employee share schemes for small businesses