What are growth shares?
Growth shares are share-based incentives that allow selected individuals to participate in the value of a company above a valuation threshold. Different from ordinary shares, growth shares are a different class of shares created to benefit from the capital value above the valuation threshold.
Growth shares typically don’t have rights to dividends or voting but are flexible and tax-efficient. They’re ideal for companies aiming for an exit, e.g. on the sale of the company or an IPO, so they’re also called exit-based incentives.
How do growth shares work?
Growth shares work by establishing a threshold (i.e. ‘’hurdle’’) that is specified at the start to encourage the future growth of the company. When growth shares are issued at a ‘hurdle price’, it is often slightly in excess of the value of the company at that time.
When the company is sold, the holders of growth shares benefit from the growth in the value of the company above the “hurdle price”. At the same time, the existing shareholders can keep the existing value of the company.
An example of growth shares
For example, a company is worth £10 million at the date of issuing its growth shares which are valued at £1,000. It sets the hurdle at £12 million, meaning recipients can only benefit from the growth above £12 million.
A senior executive of this company pays the full value of £1,000 to participate in the plan. In his plan document, he will be given 1% of the company value above the hurdle when the company is sold. Some years later, the company is sold for £20 million. The value of the growth shares for this employee is £80,000 (£20,000,000 – £12,000,000) x 1%. The gain for him is £79,000 (80,000 – £1,000) and capital gains tax (CGT) may be payable.
Tax treatment of growth shares
When they receive their growth shares, employees don’t need to pay income tax or employee NIC if they pay full market value for the shares. But, if the employees receive the growth shares at a discount, they’ll need to pay income tax and possibly NICs on the amount of the discount.
When they sell their growth shares, CGT may be payable on any value growth. CGT is more favourable, especially for higher-rate income taxpayers. No corporation tax relief will be available to the employer for any growth in the value of the employee’s shares.
Pros & Cons of growth shares
- Incentivise participants to grow the business
- Tax efficient
- Flexible design, e.g. non-employees can participate, conditions can be set for recipients and leaver provisions can apply
- Usually low acquisition costs for employees thanks to a lower market value when issued
- No dilution for existing shareholders in respect of the current company valuation (They are only diluted for growth from the hurdle)
- Growth shares don’t expire after 10 years, so they’re an ideal employee incentive for companies that do not envisage an exit in the near to medium future.
- Employees will need to pay for the growth shares at the time of grant.
- A robust valuation should be completed each time growth shares are awarded unless used in conjunction with an EMI scheme. This will bring extra workload and costs to the company as well as uncertainty because HMRC may not accept the valuation.
- It’ll be necessary to amend the articles of association of the company to create a new class of growth shares. This may result in high legal fees.
What happens if a participant quits?
It is common for growth shares to be forfeited if the participant ceases employment other than in certain ‘good leaver’ situations such as redundancy, retirement, injury and death.
How can growth shares be used in practice?
Due to high flexibility, employers can set their own eligibility criteria for acquiring growth shares. Growth shares can be awarded to
- Employees or non-employees (such as contractors, advisors and consultants)
- Wider employee population or selected employees
Growth shares are suitable for companies that
- Are privately held and have a plan to exit
- Have a higher growth value
- Already operate other employee share plans e.g. EMI option plan
How to implement growth shares?
- Create a new class of shares for growth shares for approval by amending the articles of association of the company
- Obtain the company’s current valuation
- Set up the growth share plan by establishing scheme rules
- Enter into an agreement with the relevant employees
- Issue the growth shares to the employee
Contact Global Shares now
At Global Shares, we provide businesses of all sizes with an all-in-one equity compensation management solution. We handle all the equity award administration so you’ve nothing to worry about. Get in touch to find out how we can assist with equity design and management.