Most successful high growth companies set aside between 10% to 20% of the share capital for key members of the team. In fact many investors will only want to invest in a company if it offers effective equity ownership to employees. To do this, you must ask a number of key questions before proceeding.
- Who should participate?
- How much should we offer?
- What will the employees think?
- How do we do this tax effectively?
- How do we structure the awards?
- Who should participate?
This depends on the culture that you wish to foster. Some companies offer shares only to senior executives; some offer shares to every employee. Both approaches have merit but you must make sure that those you want to retain have a material amount to lose if they leave!
How much should we offer?
This will depend but, as a guide, senior executives often get between 1 and 3% whereas junior employees may only get 0.1%. The key, however, is use percentages as a guide but never to promise a percentage of the company – always a number of shares only. All awards must be capable of dilution when further investment comes in.
What will the employees think?
Most sensible employees joining a high growth company will strongly appreciate getting a potential slice of the cake. Indeed, this is often the reason that they join a smaller company. Nevertheless, tolerance and desire for equity rather than cash will depend on the individual. The best employees are those who believe in the company and agree to invest their efforts in the hope of sharing in success on an exit – those who come in early will get share awards based on a lower valuation and so will get more reward on the exit.
How do we do this tax effectively?
The Government believes in employee share ownership. It is possible to structure awards very tax effectively for both employee and the company. Considerable care is required to avoid unpleasant income tax and National Insurance consequences – a badly designed plan can result in high tax charges when the employee may not even have cash to pay it. Properly advised companies can often award shares or grant options so that the employee may be liable only to a 10% – 20% tax rate and then only on sale of the shares. Indeed, the company may even get corporation tax relief for the gain made by the employees – essentially the Government will pay towards your incentivising your employees! With this level of support from the Government, employee share awards are often a no-brainer.
How do we structure the awards?
Companies usually award shares or grant options to the employees to acquire shares. For many smaller companies, the best form of award is to grant Enterprise Management Incentive (or EMI) share options that are very tax effective. It is vital that these are properly implemented as many companies have realized that they have not done so only on an exit when the mistake proves very costly. For those companies that do not qualify under the relevant EMI legislation, it is open to create a new employee class of ordinary shares (often called growth shares) – these can also be very tax effective.
However the awards are structured, they should help incentivise employees to stay and should be subject to a vesting schedule so that the employee keeps more of her award the longer she stays. The flip side of course is to ensure that the company can get back its equity from leavers.
Contact Jeremy Glover with any questions, or to request further information and advice.