Sharing growth is a popular way to incentivise employees

Share Incentive schemes are a popular and well-recognised way for employers to attract, motivate, incentivise and retain staff. A key advantage is that they can be set up with varying rights to incentivise growth, which is becoming increasingly popular with employers.

However, the receipt of shares and/or share options are potentially subject to income tax for the employee and a valuation of the shares or instruments over which options are granted is therefore required.

Furthermore, a good understanding of how the shares and options are valued is an important step to recognise the value being transferred, the level of incentivisation created and to ensure the scheme is designed to meet the Company’s commercial goals as well as meeting its reporting requirements. Sometimes a commercially attractive incentive scheme can create rather complex financial instruments for accounting purposes.  

This Article briefly explores the commercial considerations of a common scenario, namely Share Option Schemes over Ordinary shares.

Share Options Schemes (including HMRC approved Enterprise Management Incentive “EMI” Schemes) offer employees the option to buy shares at some point in the future, at a price set today, if certain conditions are met. The conditions are referred to as “vesting conditions” and are set by the Company. A typical scenario is that an employee can exercise their options (buying the shares) on an exit event only (sale, IPO etc.). This means the employee only owns the shares momentarily at the point the entire company is sold and benefits financially if the exercise price is lower than the exit share price.

Options can be granted over any type of share (e.g., ordinary, growth or flowering). The most common approach are options over ordinary shares, which entitle the holder to a small percentage of the total consideration at sale.

In our experience there are some commercial factors to consider during the valuation exercise. The valuation of the shares (over which the options are granted) at the grant date is based on the current market value of the Company, but discounted to reflect the fact that the option is over a minority of the share capital (commonly referred to as a minority discount). 

This discount could be up to 85% for a small minority, for example 2%, of the total equity of the business. Some interesting points to note are: 

Surplus cash in the business increases a company’s value and the employee is receiving not only the enterprise value but also the benefit of the cash already built up in the business at a significant discount. As a result, the original shareholders may wish to take this out before the business is sold.

If the exercise price is close to the current discounted minority holding market value, the overall company value does not have to grow before sale (it could even shrink significantly) and the options would still be in the money.
Is this really incentivising the employee to grow the Company or just work towards an exit event?

There will be an annual charge in the P&L reflecting the fair value of the option spread over the vesting period. Note, this value could be different than the valuation of the share to which the employees could become entitled to under the scheme.

The implications of the above factors will be different for each company. If a company considers these as disadvantages, there are other types of options which could be considered. An increasingly common approach is to issue a special new share class which entitles the employee to a share in the growth in the Company’s value only (known as Growth Shares) or to allow the employee to participate in a percentage of all the equity in an exit event once a predetermined hurdle is met (Flowering Shares). In our future articles we will explore these shares and valuations further.

We have a dedicated team of valuation and tax experts with significant experience in valuing shares and options. 

We can help you make informed decisions to help your employees and business thrive.

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