Cash is often at a premium for start-up companies and staff wages are usually an overhead which are heavily managed to maximise expenditure elsewhere, causing leakage of talented staff who receive better offers from more established businesses.
Incentive schemes are a brilliant way for start-ups to entice high calibre employees and collaborators to come on board and, more importantly, to encourage them to stay.
So what are incentive schemes and how do they work?
An incentive scheme is an opportunity for business owners to offer key employees and contributors the opportunity to realise a significant lump sum on a future sale of the company without having to find immediate financial resource to acquire shares.
Incentive schemes offer business owners the opportunity to:
- get employees engaged in the future growth of the business
- control how big a piece of the pie is given away to key employees and control the conditions as to how and when an employee acquires their interest in the business
- put in place easy to manage arrangements which simply fall away should an employee ever leave
- possibly incentivise an employee to offer affordable investment options now in the anticipation of receiving future reward with tax advantages around that reward’s treatment.
However, not every scheme suits the individual requirements of a company, so which incentive scheme should you choose? Below is a summary of the most popular schemes which business owners can choose from.
EMI Share Option Scheme
Enterprise Management Incentive (EMI) share option schemes are a form of tax advantaged option scheme created so that as a company increases in value over time, any taxable gain associated with the value of an employee’s shareholding shall be taxed at more attractive rates. Furthermore, any such tax charge would only be triggered on the sale or transfer of those shares.
EMI schemes carry no income tax liability on the grant of an option and, provided that certain requirements are met (including the exercise price for the option being at least the market value of the shares at the date of grant), no income tax will be charged at the point of exercise either. When the shares are eventually sold, if the sale qualifies for Business Asset Disposal Relief, the applicable tax rate on any capital gain will be 10%. The possibility of receiving a lump sum at the end of a defined period of time at a favourable tax rate is very attractive to prospective key employees.
In order to qualify for an EMI Scheme a company must:
- not exceed granting options beyond a maximum share value of £250,000 per employee and an aggregate share value of £3m
- not be a subsidiary of another company
- be based in the UK
- have gross assets in value of no more than £30m
- have fewer than 250 employees
- be engaged in a qualifying trade.
On creating an EMI option scheme, a business owner will have full control over:
- which employees qualify for such an option (provided they work full time for the company)
- the term of the option period
- the size of the shareholding being made available under the option
- what performance targets or events trigger the employee’s ability to acquire shares – for example, it may be the case that the option can only be exercised immediately before the sale of the company to a third party.
Unapproved share options
If, for whatever reason, a company does not qualify for an EMI option scheme, share options can still prove to be a cost-efficient and flexible way of incentivising employees and non-employees alike. Unapproved share options have the advantage of not requiring prior approval from HMRC; they offer the same controls to a business owner as offered under an EMI option scheme, but the incentives for an employee are not as strong due to their tax treatment.
Although no income tax will be payable on the date of grant, income tax will be payable, together with National Insurance contributions, on the exercise of the option. Again, provided the requisite conditions are met, an employee holding unapproved share options may still qualify for Business Asset Disposal Relief on the sale of the shares.
Despite the tax consequences of an unapproved option, it is still a good way of engaging and incentivising employees if an EMI Scheme is not possible.
Issuing shares instead
Where an immediate issue of shares has been agreed with an employee/consultant, but that individual does not have the funds immediately available to pay for them, it is possible to issue shares as “nil paid” deferring payment for a set period. This ultimately must eventually be settled by the recipient. The risk to any employee is that the shares lose value before the debt owed to the company is repaid.
From a taxation perspective, such an issue of shares would not be subject to income tax or national insurance provided that the shares are purchased for market value, but capital gains tax would be payable on any disposal. Again, provided the requirements are met, Business Asset Disposal Relief may apply, bringing the rate of tax down accordingly.
Another popular option for companies who do not qualify for EMI schemes is to issue growth shares. Growth shares are designed to reward recipients for growth in the value of the company beyond a set value which is determined at the date of issue. Only once the condition is met will the shares have value. If you are considering growth shares for your company, you should seek specialised tax advice because an issue of such shares could undermine previous efforts to raise finance in the company by way of investment.
One possible downside of issuing shares at the outset, is that you will need to go through a form of mechanism to get the shares back if the employee leaves, which can become problematic especially if the employee does not cooperate. It is therefore vitally important that you have the correct provisions in place in your shareholders agreement and articles of association to ensure there is a mechanism in place to get the shares back as easily as possible.