With the current uncertain economic climate and the lack of affordable finance constraining many companies from growing by acquisition or other traditional means, now is a good time for businesses to consider other expansion options as well as ensuring that the company is ready for a sale should the opportunity arise.
Increasingly small and medium sized (“SME”) companies with less than 250 employees (particularly higher - risk trading, knowledge based ones), are looking to their human capital to stimulate growth. Finance may be tight but share options allow you to recruit and retain talented individuals who can help to expand your business having the incentive to do that as they will be rewarded when the value of the shares is on the up.
The Enterprise Management Incentive (“EMI”) Scheme is widely considered the most flexible and suitable approved scheme for SME companies (with the exception of those companies that cannot use EMI options because theirs is not a “qualifying trade”). It provides very favourable tax benefits for both the option holder and the company setting up the scheme.
Key benefits
The EMI scheme is so flexible that it allows the company to:
- obtain a statutory corporation tax deduction on the market value of the shares issued or transferred to satisfy EMI options
- choose exactly which eligible employees receive the options (subject to an employee and his associates not exceeding the 30% “material interest” barrier)
- grant the options conditionally subject to tailored performance criteria or an exit event occurring
- determine the option period and exercise price (i.e. it can be below market value on the date of exercise)
- place voting restrictions over the shares (i.e. so as to protect the core owner’s position, inferior voting and dividend rights may attach to the EMI Scheme shares)
- grant options without first obtaining the prior approval of HMRC.
For the employee with an EMI Option, the tax advantages are:
- On grant - there are generally no income tax or national insurance implications when the EMI Option is granted.
- On exercise - provided that the exercise price is equal to or greater than the market value at the date of grant, there will be no income tax or national insurance at exercise. A formal share valuation exercise should be carried out for this purpose and that valuation agreed with HMRC’s Share Valuation Division. If the options are issued at a discount, then income tax and national insurance shall apply to the value of the discount and will be charged at the time of exercise.
- On disposal - When the shares are disposed of a capital gains tax charge at 28% or less will arise. For Entrepreneurs' Relief purposes the shares shall be treated as being acquired at the date of exercise of the option.
Exit issues
If you are considering a sale of your company in the future and are looking to incentivise key employees to help you achieve that exit, you should implement the EMI Scheme as soon as possible and in any event in good time before you commence talks with potential buyers. This will help to ensure that your scheme can be validly implemented, as the scheme may not be valid before a sale or otherwise may not afford any tax benefits to the option holders.
If you are considering a sale of your company and have existing unexercised EMI options, you should review the terms of the options and look into the practical steps that need to be taken by the company and the option holders so that the options can be exercised preferably immediately before completion and without the risk of any loss of the tax benefits.
The availability or otherwise of Entrepreneurs’ Relief on the existing shareholders of the company and the option holders must not be overlooked. Entrepreneurs’ Relief reduces the capital gains tax liability on the sale of shares from 28% to an effective rate of 10%. In order to be eligible for the relief, the relevant shareholder must be an officer or employee of a trading company or the holding company of a trading group for at least 12 months before the date of sale and must hold at least 5% of the shares (allowing him to exercise voting rights in respect of those shares). Where EMI option holders can only exercise their options on completion of a sale (”exit only EMI Options”), they will not be eligible for Entrepreneur’s Relief for failing to own the shares for the required period of 12 months even if, after exercise, they would have satisfied the required 5% shareholding rule. This should be taken into account where exit only EMI Options are offered to employees and, if so, consideration may need to be given to amending the original exercise conditions to permit early exercise and secure the Entrepreneur’s Relief. Be aware, though, that HMRC may consider that a fundamental amendment to an EMI Option may amount to the grant of a new option that would not benefit from the same tax advantages as the original EMI Option.
Where, as is increasingly common, the price structure includes deferred monies payable conditional on performance milestones being achieved after completion (an “earn-out”), great care should be taken to ensure that the tax position of the option holders does not conflict with that of the existing shareholders. Existing shareholders may prefer to maximise the taxable value of the right to receive earn-out proceeds in the future so that Entrepreneurs’ Relief applies to most of the amount they expect to receive from the sale of their shares, as the relief may not apply when they actually receive the earn-out. Option holders who participate in the earn-out, on the other hand, may prefer the taxable value of this right to be smaller as they may not be able to get the benefit of the Entrepreneur’s Relief and may end up with a larger upfront tax bill than the amount they expect to receive on completion from the sale of their shares. These conflicting tax positions can give rise to challenging discussions between the parties, particularly if the Option holders are seen by the existing shareholders as essential to the success of the earn out (the fruits of which will be enjoyed mainly by the existing shareholders).
