Richard Goold and Jonathan Crookham of EY explore the different ways in which you can give equity to your employees, which can act as a great company perk and employee incentive.
The opportunity to participate in the ownership of the company and (hopefully!) share in its success is a popular differentiator to attract, retain and incentivise employees. This is particularly the case with smaller or newer businesses which may use equity participation in part because they may not be able to compete on salary levels, but still need to recruit the best people to help grow the business.
Why offer shares rather than cash?
In addition to the cash-flow advantage, ownership of company shares (or awards to acquire shares) can help to align the employees with the business strategy and increase shareholder value. Delivering the reward via shares can be very cost efficient. It maximises the net return for the employee and reduces direct employer costs, and the retention elements can help minimise indirect costs such as recruitment costs caused by attrition.
The payment of cash to reward employees will always be subject to income tax and National Insurance contributions (NI). Share incentives can, if structured optimally, deliver rewards at capital gains tax rates (which can be as low as 10% or exempt from tax) and free from NI.
Giving an employee shares in a company is one way a company can incentivise employees and align their interests with those of the business. However, there are certain company law and tax law issues that need to be considered before progressing with this option.
An important thing to remember is that once an employee holds shares they are a shareholder in the company and therefore the ownership of the company is diluted from day one. The employee may also have a say in the running of the company, depending on what rights are attached to the shares they hold.
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The company will need to decide what shares the employee will receive and if anything should be paid for them.
Common concerns, such as what to do with shares if and when the employee leaves and how to deal with minority shareholders, can be picked up through appropriate drafting of the company’s articles of association. For leavers, provisions can be included for shares to be returned to the company, which can distinguish between “good” and “bad” leavers as appropriate.
A share option, by comparison, gives the employee the right to acquire shares in a company at some point in the future for a pre-set price.
An employee who is granted an option does not become a shareholder until they exercise their option to purchase the shares. An option can be structured so that it can only be exercised at certain times or on certain events, such as a sale or listing of the company, so that the employee is incentivised to work to further the company’s strategy without diluting the ownership of the company unless the end goal is achieved.
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With share options, rules regarding leavers can easily be picked up through the award documentation, without necessarily needing any changes to be made to the company’s articles.
If certain conditions are met, an employee share option can benefit from attractive tax savings for both the employee and employer.
A popular employee share scheme which is designed to help smaller companies recruit, retain and incentivise key employees is known as an Enterprise Management Incentive (EMI) share option scheme. The key benefit of an EMI option is that employees only pay capital gains tax when they sell the shares acquired, and the tax rate can be as low as 10% if certain conditions are met and Entrepreneur’s Relief is available. If structured correctly, there should be no income tax for the employee to pay and there are no NI charges.
An unapproved option does not carry these tax advantages and a top rate taxpayer would be subject to income tax at 45% and (if payable) employee NI at 2% on exercise, along with the company having to pay 13.8% employer NI.
What is right for you?
Determining whether equity incentives are appropriate, and the right course of action, will depend on the specific circumstances of the business. The focus should be on designing a suitable reward strategy in the context of the overall business strategy. Employee equity may well be a key component of this to ensure your employees are incentivised to work towards achieving your common goals.