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Employee Share Schemes

Published: 27th April 2009

Introduction

Ian Hodgkinson corporate partner at North West law firm Mace & Jones explains the background to employee share schemes. Why they are an excellent way of recruiting, retaining, incentivising and motivating employees. And why, in the jaws of a recession, they offer employers a way of incentivising staff without paying out cash bonuses and without hitting the bottom line.

This article focuses on the main kind of employee share scheme used by private companies which is the EMI (Enterprise Management Incentive) scheme.

Why have employee share schemes?

In short they are a terrific way of incentivising key members of staff, showing them they are important to the firm. But at the same time as tying employees into the success of the company there is no real downside for the employer. If the employee never exercises the share options, and never acquires shares, then the share options costs the employer nothing.

Moreover, share option schemes can be drafted so they only give the right to exercise the share option when the company is to be sold. In this way option holders will not be shareholders prior to the date of exercise, and critically will not have voting rights or be entitled to dividends. This ensures the employer and key shareholders keep the financial benefits of running the firm and maintain control of decision making. .

It is possible to have "cashless" exercises of options so payable by the employee (to enable him to acquire his shares) can simply be 'set off' from the sale proceeds due to the employee when the company is sold, rather than the employee having to borrow to raise the cash to pay for the shares.

There is, however, likely to be a move away from employees only exercising options on sale. This is because many employees will not qualify for entrepreneurs' relief, for which an employee must have held at least five per cent of the voting share capital for a one year period. We may see more schemes where employees can acquire shares once they have been an employee for, say, three to five years.

Should schemes have performance criteria?

Share options can contain performance criteria, so that the employee only has the right to exercise the share option, and acquire shares, if certain criteria have been met.

Before including performance criteria, employers should think about the main reason for granting the share option - is it a reward for past performance? If so, performance criteria are probably inappropriate,. Or are they to incentivise the employee in the future? If so, it is probably sensible to include them.

Performance criteria should be clear and objective. The key to successful performance criteria is to ensure that they are genuine incentives. They should be balanced by being stretching but achievable.

Enterprise Management Incentive (EMI) options

EMI share option schemes enjoy very favourable tax treatment. If drafted in a particular way no income tax or national insurance charge arises on the grant of the option or on its exercise.

EMI qualifying criteria - company

EMI options can be granted by independent trading companies with gross assets of no more than £30 million as at the date of grant of the EMI option.

Certain trades will not qualify. These include companies who deal in land, banking, insurance, financial services, legal and accounting services and similar, and companies engaged in steel, coal or shipbuilding. Asset backed companies tend not to qualify e.g. companies who operate hotels, farms and nursing homes. Also they must carry on a trade wholly or mainly in the UK on a commercial basis with a view to making a profit and which does not, to any material extent, consist of carrying on the excluded activities set out above.

Companies have to be independent, that is not a subsidiary of or controlled by another company. Accordingly, options have to be issued by the holding company to employees of trading subsidiaries.

Only companies with fewer than 250 employees will qualify for EMI options.

EMI qualifying criteria - employee

All full time working employees can qualify. They must work for the company for at least 25 hours per week or not less than 75 per cent of his/her working time to benefit.

Employees must not otherwise have a material interest in the company - meaning an interest directly or indirectly of 30 per cent or more in the ordinary share capital of the company.

An employee can hold unexercised EMI options over shares worth up to £120,000 as at the date of their grant. Any amount over that will not qualify for EMI treatment.

EMI qualifying criteria - share option contract/ rules

EMI schemes can be very flexible and the company can include almost whatever it likes in terms of rules and conditions provided it complies with the rules set out below.

The shares over which the EMI option subsist must be ordinary shares, fully paid up, and not, for example, redeemable or convertible shares.

The EMI option must be capable of exercise within 10 years of the date of grant.

The EMI option must prohibit the employee from transferring his option rights, save on death.

Agreeing the price and taxation implications

The company will decide at the date of grant the number of shares over which the option should subsist. It is preferable for this to be over a fixed number of shares. HMRC does not like share options which are for a variable number of shares.

The next step is to decide what the exercise price will be. Usually the exercise price will be the market value of the shares as at the date the option is entered into. Usually the exercise price is agreed in advance by the company's accountants and HMRC's Share Valuation Division and is generally discounted by up to 80 per cent of the full market value to take account of the "minority interest" that the shares represent.

Provided the market value of the shares has been agreed with HMRC, and this agreed valuation is at least the exercise price in the EMI share option, the only monies that will be due and payable by the employee on eventual exercise of the EMI option will be the exercise price per share. No income tax or NICs will be payable.

The tax advantages associated with EMI share options can be lost if a "disqualifying event" occurs unless the option is exercised within 40 days of the occurrence of the disqualifying event.

Disqualifying events include, the company ceasing to be independent, ceasing to meet the trading requirements and the employee no longer being a qualifying employee.

Effect of termination of employment

Options are normally drafted so that if an employee leaves the employment of the company for any reason, the share option will lapse and the employee will lose all their associated rights. Often the board has the discretion to resolve that, notwithstanding the employee's departure, they can retain their share options. If the board exercises this discretion and allows the employee to keep his/her shares, they may wish to ensure the company can ultimately get those shares back if it so requires/desires.

The scheme can contain good/bad leaver provisions so that in a "bad leaver" situation, such as dismissal for dishonesty, the share option will lapse; in a "good leaver" situation, the employee retains the right to exercise the share option, notwithstanding that they are no longer an employee.

If an employee leaves the employment of the company, this is a disqualifying event for EMI purposes. If the employee retains share options, but then does not exercise them within 40 days, but, in effect, the options become non-approved options with all the associated tax rules.

Controlling transfers of shares

Under any form of share scheme, if an employee is entitled to acquire shares in the company, then it is important that if the company so requires/desires, it can get those shares back from the employee concerned.

In addition it is also usual to include share transfer provisions so that employees cannot freely transfer their shares. A company may not be happy for an employee to transfer their shares to relatives or other third parties who are not employed by the company.

There will usually be pre emption provisions whereby employees have to offer their shares to other shareholders and/or the company before they could transfer them to an unconnected third party.

Well drafted schemes may also include 'drag and tag' provisions. The company constitution can say that if a majority of the shareholders wish to sell their shares to a third party, they can compel the minority shareholders to also sell their shares, provided they are sold on the same terms. This is to prevent minority shareholders being able to obstruct a sale of the whole company.

Just as important can be provisions which say that if a party wants to make an offer for a majority of the shares, they have to make an offer for the whole company, not just the majority. This is to prevent majority shareholders negotiating sales for their benefit alone.

Amending existing schemes

Option schemes which are "underwater", meaning that the current value of the shares is now below the exercise price of options previously granted as result of the recession, should be reviewed and if necessary amended. If the prospect of achieving a share price that puts the employees "in the money" simply seems unachievable the schemes may have lost their incentive value.

Alternatives to option schemes

Option schemes may become less popular where an employee will hold less than 5 per cent of the shares, as a result of the restrictions on entrepreneur's relief. Schemes that involve an actual issue of shares may be appropriate in those circumstances. We anticipate an increase in the use of schemes where shares are issued partly paid, to make them more affordable for employees, and "growth" and "freezer" schemes, which effectively give the employee shareholders a share in only the future increase in value of the company. This means that they can buy them at a low but genuine market value, resulting in a much diminished tax liability for them at the time of purchase.

Conclusion

Option schemes are well worth considering while low base values can be justified and cash is tight. However, detailed thought and expert legal advice is needed to tailor them to the particular circumstances of the company involved. Please note this article summarises the law before the April 2009 budget.

ian.hodgkinson@maceandjones.co.uk, corporate partner, http://www.maceandjones.co.uk/ tel: 0151 236 8989.