How companies can utilise share option schemes to incentivise key employees

The popularity of incentivising key employees with capital rather than income is ever increasing. Whether as a result of the business’ fiscal situation or as a result of economic downturns, such as a recession or national crisis (as we have witnessed with the Covid-19 outbreak), companies are often not in a position to appropriately reward staff and incentivise them to maintain the high standard of work and value they provide to the business through salary alone. Equally, the company may identify key employees as potential future leaders and therefore want to provide those individuals with encouragement to drive the business forward for mutual gains.

The popularity of incentivising key employees with capital rather than income is ever increasing. Whether as a result of the business’ fiscal situation or as a result of economic downturns, such as a recession or national crisis (as we have witnessed with the Covid-19 outbreak), companies are often not in a position to appropriately reward staff and incentivise them to maintain the high standard of work and value they provide to the business through salary alone. Equally, the company may identify key employees as potential future leaders and therefore want to provide those individuals with encouragement to drive the business forward for mutual gains.

Whatever the circumstance, there are numerous types of share schemes available to business owners that either grant employees shares in the business, or the right to acquire such shares at a later date, for a beneficial price. The challenge comes in providing those shares in a way that feels like a reward or reason to continue adding value while balancing that against the tax outcome for all parties.

If employees are given shares today, they will be heavily taxed. Whereas if, instead, the employee is given an option over equity or the promise over the future uplift in equity value; e.g. the option to buy shares, at today’s value, in the future when they’re expected to be worth more, the tax point is deferred, and there is the opportunity that the level of tax paid can be reduced.

While it is both sensible and financially beneficial to find a tax-efficient solution to incentivising key employees, it is vital to ensure that the chosen mechanism aligns both with the shareholders’ strategic aims and the companies culture and values – even if that means following a less tax-efficient option.

Approved Schemes available

Enterprise Management Incentive plan (EMI)

The option scheme that we work with most frequently, and often in the SME sector, is the EMI scheme. EMI is available to most businesses except those that HMRC deems as ‘excluded trades’, e.g. accountants, lawyers, property businesses, who cannot use it and those exceeding the size requirement; those businesses with more than 250 employees.

The tax reliefs available through EMI are extremely generous:

Advantages to the employer:

  • EMI is commercially beneficial as at the point the options are exercised, the business will qualify for a deduction in corporation tax in that accounting period.
  • In addition, the company is able to record the difference between what was paid and what was received for the shares as extra staff costs to offset against profits for the year.

Advantages to the employee:

They do not have to pay income tax on the granting of options or on exercise of the options (on the basis that the option was not granted at a discount to the value of the shares at the point they were granted, and the options are exercised within ten years of being granted).

  • Capital gains tax (CGT) and Entrepreneurs’ Relief (ER)
  • CGT is chargeable on any uplift in excess of the exercise price. CGT is at a rate of 20%; however, there is no NI payable meaning it is still at a better rate than what would be paid on their salary. For those with income and gains below the higher rate of income tax of £50,000 (2020/21), CGT is charged at a lower rate of 10%.
  • However, EMI holders usually benefit from ER, meaning that they pay CGT at the lower 10% rate on the first £1m of lifetime gains.

Some of the other approved share schemes available are summarised below; these are generally more suitable for larger corporates than SMEs.

Share Incentive Plan (SIP)

Employees, in essence, can buy shares in the company up to the value of £1,500 each tax year directly from their gross salary. The business then has the option to match, giving up to two shares for each share purchased by the employee.

The tax benefits of a SIP are that there is no income tax or NICs for employee or employer payable if the shares are held in the SIP for five years. After a five year holding period, the shareholder can sell their shares free of CGT.

IMPORTANT NOTE: Generally speaking, if the business’ aim is to incentivise individuals that are key to the future of the business, they are unlikely to be incentivised by a SIP. Instead, mechanisms like SIPs are designed as a loyalty incentive, or in lieu of market-rate salaries.

Save As You Earn plan (SAYE)

SAYE works slightly differently; under this plan, employees invest up to £500 per month into a special savings account for a period of 3-5 years. At the end of the 3-5 years, the employee has the option to use the money in the account to either:

  • buy shares in the company at the price set at the time the employee’s account was set up (this can either be at the market value of the time or at a discount of up to 80% of the market value), or
  • take the money out tax-free.

The tax benefits with an SAYE are that the interest and any bonus at the end of the scheme are tax-free and there is no income tax or NIC on the difference between the price paid for the shares and their market value.

If any employee subsequently sells the shares acquired under the SAYE, CGT is payable. The CGT rate paid is calculated by the difference between the price sold, less the acquisition price. If the gain earnt is above £10,000 then CGT is charged at 18%.

A SAYE, whilst popular, is generally the more expensive scheme to set up and run.

Company Share Option Plan (CSOP)

Where EMI is not available, a CSOP may be an available alternative, particularly in a high growth situation as the company will trade a large upside at a good tax rate.

In a CSOP, the company grants the employee the option to purchase up to £30,000 worth of shares at a fixed price; ordinarily, the option is granted to purchase at a set time in the future at today’s price. No income tax or NIC for the employee or employer is payable at the point the option is granted or exercised, subject to a holding period of at least three years. CGT is usually payable when the shares are sold.

There are, of course, a number of criteria and conditions to each scheme that a business must meet in order to be able to qualify to set up the scheme. However, certainly for the SME market, EMI surpasses the other options for both the tax benefits available and for the simplicity of the scheme’s set up and management.

There are other non-legislated ways of achieving similar results as these schemes set out to achieve; for instance, growth shares are a type of share with certain capital rights and restrictions, typically set up to reward holders for the growth in value of the company above a threshold specified on issue.

A ‘thank you’ vs ‘future promise.’

We’ve already alluded above that companies utilise share schemes for either compensation or incentive arrangements – i.e. as a thank you and/or as a way to ensure they continue to create value in the future.

If a company has a key employee that has already contributed to the value of the business, they may consider providing options to those individuals on a heavily discounted price to the normal minority shareholder value, as a way of saying ‘thank you’.

In contrast, in the instance when someone has been taken on to grow the business beyond a certain value, e.g. 50p per share, then it would make sense that they would have to buy in at 50p. If at the point of buying in, the market value of those shares is less than 50p, then their shares are what are described as ‘underwater’. This way, and provided they have the capability to do so, they are incentivised to grow the value of the shares beyond 50p and realise the gain. Ordinarily, in this instance, the rewards would be a much larger % of the pie than someone being offered a simple discount on options.

When options aren’t the right incentive

Options work best in circumstances when the value of the business is set to increase at a notable amount. It is important for employers to understand that shares, in the form of options, are giving away some of today’s or tomorrow’s value. Therefore, options will only act as an incentive if the option holder can see there is sufficient value, or value potential, available today or tomorrow. If there isn’t, then it is perhaps better to offer bonuses. Whilst bonuses are less tax-efficient, they may be the best mechanism to drive employees to push the business forward. Often a combination of the two is used.

Equally, as we mentioned earlier, it is vital that any scheme is aligned with the culture and values of the company. Therefore, sometimes tax benefits are set aside completely in order to make an intentional, cultural gesture to the employees.

An example of this is Price Bailey’s All Employee Share Ownership Plan.

In June 2015, Price Bailey began offering its employees a stake in the firm. The scheme that was set up gave each employee with more than one year’s service, irrespective of their grade, 25,000 shares in the firm at a value of approximately £250. It is predicted that, from the share being granted, they will increase in value in the region of 10 per cent per annum, and holders will receive an annual dividend when performance allows.

The scheme is not an approved tax incentive scheme meaning that, in addition to existing shareholders’ dilution, the firm pays both income tax and employers’ NIC on each issue of shares, to give the maximum benefit to our employees. Our employees pay normal rates of tax on any dividend received.

However, the Board and Partners’ aim in designing the scheme was not first and foremost to find a tax beneficial scheme for the firm, and instead, the focus was to find a way to reinforce our cultural values and have everyone benefit in the success of the business.

Flexibility in design

Generally speaking, the design of an option scheme is fairly unrestricted. The only restriction in law is dictated by the company’s Articles. Therefore, if flexibility has been built into the Articles, then there is flexibility in the scheme.

The only other potential restrictions when using an advantage scheme is when there is a framework drafted in law, as is the case with EMI where, e.g. options cannot be transferred and must lapse within 12 months of death, and the tax relief must be secured by filing an online notification with HMRC within 92 days of grant. However, even in this instance, the company can draft in performance conditions and requirements of the option holder at the company’s discretion.


Bad leavers

If a business has gone down the route of giving shares outright, as opposed to options over shares in the future, then the main challenge comes if the individuals don’t work out. Whilst they may no longer operate in the business, they maintain a capital interest in the business.

Shareholder interactions are governed by the company’s Articles and Shareholder Agreement, which are often not considered well in start-up business. If ‘worst-case scenarios’ are not considered appropriate in their drafting the business could be in a position where shareholders have to buy out bad leavers, sometimes paying a premium to do so, which can leave a bad taste in the mouth! If the business itself (rather than people) does not work out, this isn’t a challenge because the shares consequently lose some or all of their value. At Price Bailey, we would typically work with the lawyers to make sure there are no own goals in there in the instance that things don’t work out.

Often we insist on putting in place performance conditions, and shares are only given as options to the individual if performance is as defined. This can be a very powerful tool to get the best out of the best people, but also to recycle options for those that aren’t performing well.

Other common challenges

  • Contractors – It is a common misconception that approved schemes can extend to non-employees, e.g. contractors. As contractors are not employees on the company’s payroll, they will not be able to benefit from tax advantages schemes. Instead, if they are provided with options or share incentives, the tax outcome normally falls on the individual rather than the company.
  • Non-tax residents – Employees with tax residency in a jurisdiction outside of the UK can still benefit from a scheme, but there are generally more complicated. Generally, they will receive the same economic advantage, but this will ultimately depend on the tax regime in the resident jurisdiction.
  • Exit – exits are rarely considered well enough in advance, and if you have a larger number of shareholders to consider and consult, particularly those that are not business-minded, then the exit process can be challenging both commercially and emotionally. Discussing and considering potential exit options at the point of drawing up an options/ incentive scheme can be extremely beneficial.

If you are considering the best way to incentivise your employees and not sure what the best option is for you, your business and your employees. Please contact Richard Grimster on the form below.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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