Introduction

In recent years, the use of employee share schemes as part of company benefits packages has become commonplace. This results from a combination of factors:

In the UK about 92 per cent. of listed UK companies now offer some form of employee share scheme, with a total of more than 3.5 million participants. Amongst smaller UK companies, there is currently a rapid growth in the use of share option schemes, due in part to the attractive tax incentives now on offer through the Enterprise Management Incentive.

In the US, the use of employee share schemes is even more widespread, to the point where some executives are now paid only in shares. Share schemes are also available in many other developed countries and are particularly widespread in France, Canada and Australia.

Main types of employee share scheme

There are three ways in which employees can be provided with an interest in the shares of their employing company:

Statutory and non-statutory schemes

In general, all benefits arising from employment are subject to income tax. However, successive UK governments have been keen to encourage employee share ownership because it is perceived to have positive effects on company performance. The result has been the introduction of a variety of schemes which offer substantial tax advantages. These are referred to in this Guide as “statutory schemes”. However, to prevent large scale tax avoidance, statutory schemes are subject to detailed rules and restrictions.

Statutory schemes are available for each of the three broad types of arrangement identified above:

  1. Gift of shares: Under an Approved Share Incentive Plan, employees receive appropriations[1] of shares which are held for them in a special employee trust. Favourable tax treatment is available if the shares are held in the trust for 3 years, and the value of the shares is free of all taxes if the shares are held for at least five years. This is in line with the government’s objective of encouraging employers to offer incentives linked to share price performance over the medium term and not as a short term substitute for taxable salary. With certain exceptions, the scheme must be offered to all employees.
  2. Purchase of shares: Employees may also receive the opportunity to purchase shares on advantageous terms, either through the Approved Share Incentive Plan or the Approved SAYE Option Scheme. Both schemes must be offered to the workforce generally. Again the tax advantages accrue over the medium term. 
  3. Share options: There are two other Government statutory share option schemes, the Enterprise Management Incentive and the Approved CSOP Scheme. In general, the benefits are subject to capital gains tax, not income tax, and any capital gains tax may be reduced by available reliefs. Employers can select the recipients of these options at their discretion. 

Employers may also offer share incentives outside the government schemes. These are still regulated by the Taxes Acts but enjoy no statutory reliefs and according they are referred to in the Guide as “non-statutory” schemes. They carry no specific tax advantages but may still offer opportunities for favourable tax planning and also provide greater freedom in scheme design.

Effectiveness of schemes

Any company considering the introduction of an employee scheme will be keen to know if it is likely to be successful in meeting company objectives.

There is a great deal of anecdotal evidence to suggest a positive link between the introduction of employee share ownership and company performance. This has led to a broad consensus from all sides of industry that employee share incentive schemes contribute to improved company performance. For this reason, all UK governments since 1978 have offered substantial tax concessions to encourage employers to offer such schemes.

Research by Professor Richard Freeman of Harvard and Michael Conyon, undertaken in 2001 across 300 UK companies and a five year time period, found significant productivity gains in companies that had introduced share schemes, as follows:

Scheme Type

Average gain in productivity

SAYE Option Schemes

4 per cent.

Discretionary share options

12 per cent.

All-employee schemes (gift of shares)

17 per cent.

Evidence is also available from the share price movements of quoted companies. Statistics collated by the consultancy Equity Incentives Limited in the early 2000s indicated that over a short period, quoted companies offering employee share schemes had under-performed other quoted companies. This may have stemmed from the fact that employee share ownership is particularly widespread among companies in the IT, media and business support sectors, which experienced a strong downturn during these years. Over a 3-year or 5-year view, however, companies offering employee share schemes strongly outperformed the stock market averages. Similar results have been found in France, the US and Canada.

We believe that care should be taken in attributing a direct causal link between employee share schemes and improved company performance since both are likely to be correlated with progressive management.

In April 2004 HM Revenue & Customs published the results of a survey, undertaken by FDS International Ltd., of 91 companies which had adopted EMI share option schemes. The survey concluded that in certain sectors, such as IT, biotechnology, advertising and film, share options are now regarded as a normal part of employee rewards. The options were generally seen as a motivational tool to help retain and attract important staff, and in turn boost company performance.

Articles and capital structure

The Companies Act contains a number of specific provisions for employee share schemes. For example, the Directors can allot shares for employee schemes even if their general powers to allot (which must normally be renewed every five years) have lapsed. The normal presumption that all new shares in a company must be offered to existing shareholders is waived for employee share schemes. However, there are a number of other matters that should be checked, including the following:

The company may also need to consider whether its capital structure is appropriate for an employee share scheme. In many private companies a capital reconstruction will be required to increase the number of shares in issue and reduce the fair value per share to a sensible level that can be used in an employee share scheme – usually between £1 and £10. There is also a presentational issue; employees may be more impressed by the grant of options over a larger number of shares of lower value than a smaller number of shares of higher value. 

Where a company has very few issued shares, some or all of the following steps may be needed: 

In other cases there may be sufficient share capital but of the wrong type or value: in these cases a consolidation and/or reconstruction may be needed. It may also be necessary to create a new class of share for the scheme – for example, a class of non-voting shares so that the scheme does not disturb the balance of voting control. 

If a bonus issue of shares is made, the shares must be credited as fully paid and this requires the company to pay up their nominal value before issue. In most cases this should be done from distributable reserves,[3] so if there are no such reserves a scrip issue may be impractical. 

In theory any number of shares can be created through subdivision. However the greater the number created the smaller the nominal value of each will become. Although there is no rule to prevent this, there is a perception in some quarters that shares with a very low par value of say 0.001p are somehow “second rate”.

Alterations to the memorandum or articles of association, or to the share capital, will generally require a special or written resolution of the shareholders (see Glossary).

In quoted companies, alterations to the share capital are generally not needed and the Articles will normally provide the Directors with general powers to operate employee share schemes. However companies listed on the London Stock Exchange (and most other major exchanges) must normally obtain the permission of shareholders in general meeting for any employee share schemes which they propose to operate. These permissions are given by ordinary resolution (see Glossary). They can be general in nature, giving permissions over a number of years, and often include specific limits on the number of shares that can be issued for this purpose. In the UK these may be framed to take into account the guidelines issued by the Association of British Insurers (see below). 

The ABI guidelines

Directors often ask for guidance on the proportion of share capital they should set aside for employee share schemes. There can be no clear answer to this since the proportion will depend on whether all employees, or only selected employees, are to participate; on the total cost of employee remuneration in relation to profits; and on the competitive position of the company. In very general terms it can be said that most companies that introduce schemes allocate somewhere between 5 and 15 per cent. of their share capital for this purpose. There are a considerable number of exceptions.

The Association of British Insurers (“ABI”), with the support of the National Association of Pension Funds, issues detailed guidelines in relation to the remuneration of employees and directors, including employee share awards. Its principal objectives are to discourage company directors from voting themselves excessive rewards at the expense of institutional shareholders, and to ensure share based awards are linked to performance and properly monitored. The guidelines have no legal force but the ABI has the power to recommend that their members refuse to invest in the shares of companies that fail to comply.

The guidelines include the following, in relation to share-based awards:[4]

The term “share-based awards” includes any arrangement, such as share appreciation rights (see Glossary), where the value of gains in share value is satisfied in cash instead of shares. Although not explicitly stated, it appears that the guidelines are not intended to cover the use of existing (as opposed to new) shares for the purposes of employee incentives. Such arrangements could include the gift of shares by an existing shareholder to a discretionary trust which then grants options to employees. However this also appears to be inconsistent with the position taken by the guidelines with respect to treasury shares (see above).

The guidelines assume that all quoted companies will have duly constituted remuneration committees whose tasks will include the formulation of performance conditions and the monitoring of their application. The committee is expected to state whether an annual review of the arrangements has been undertaken and confirm that the incentive arrangements are still appropriate and internally consistent. Performance conditions are to be examined for lack of distortion and consistency over time, especially where changes to accounting treatment are introduced. When share awards vest, the committee should provide an analysis of achievement against the performance conditions set. Any recruitment or retention arrangements which represent a departure from previous practice must be disclosed and explained in full.

The guidelines appear to discourage arrangements where the award itself (as opposed to the vesting of the award) is conditional on performance, and suggests that these be approved only where they can be justified on the grounds of international competitiveness. No reasoning is advanced for this position. 

The guidelines are not applicable to companies that do not have institutional shareholders and most of the private company sector is therefore unaffected. Private companies which are planning to attract institutional investment through flotation should also not be concerned. This is because the company’s shareholding structure, which may or may not include employee shareholders, will be a known fact at flotation and institutional investors will take their investment decisions accordingly. 

A significant number of quoted companies, especially rapidly growing smaller companies, do not observe the ABI guidelines in relation to employee share awards. These companies often choose to approach their institutional investors directly to seek support for their incentive arrangements. If institutional shareholders are supportive the ABI guidelines might be regarded as being of limited relevance.

The Pre-Emption Group[13] is another non-statutory organisation which publishes guidance (“Statement of Principles”) on the disapplication of pre-emption rights (see Glossary) and monitors and reports on how this guidance is applied. It is supported by the ABI, the National Association of Pension Funds and the Investment Management Association. The guidance is intended for listed companies only, and not for companies quoted on AIM or other public markets.

The guidance distinguishes between “routine” and “non-routine” proposals to issue shares on a non pre-emptive basis. Shareholders should normally regard non pre-emptive issues as routine if they amount to less than 5 per cent. of share capital in any year, including issues of Treasury Shares (see Glossary) and not more than 7.5 per cent. over any rolling three year period, not including issues of Treasury Shares. If the issue is not routine, management should be able to present a strong business case, including reference to the size and stage of development of the company. Management should demonstrate a strong record of governance and be able to explain what other financing options are available, the level of dilution of value and control for existing shareholders, how the non pre-emptive issue would be managed if shareholder approval was given and what contingency plans are in place should approval not be given.

The guidance suggests that securities issued on a non pre-emptive basis should be at a discount of not more than 5 per cent. to the prevailing market value.

Use of share schemes by unquoted companies

Although share schemes, both statutory and non-statutory, are widely used by UK quoted companies, the picture is very different in the unquoted sector. Only a small minority, probably fewer than 5 per cent., offer equity incentives to their staff. 

For many unquoted companies their single biggest challenge is to attract and retain staff of good quality. They are often competing with larger companies with deeper pockets and perhaps a stronger “brand name” to offer. If these larger companies are also offering tax-efficient employee share schemes, it is clear that the odds are stacked heavily against unquoted companies.

Why then do so many unquoted companies still not make use of equity incentives? There are several reasons, based mainly on misconceptions:

Despite these misconceptions the number of private companies offering employee share incentives continues to grow rapidly. This appetite does not appear to be diminished by periods of stock market volatility since for private companies stock market values are only indirectly relevant. The real issue for most private companies is how to create value in their own businesses. The implications of success or failure will far outweigh even large movements in stock market averages.

For many private companies there is the prospect that one day they may float on a public stock exchange. Prior to flotation, the company’s share structure should be as simple as possible. The owners should resist the temptation to create multiple classes of capital for employee share schemes, or if they do, there should be clear plans for simplification of the capital structure before the flotation takes place.[14]

If there is a possibility of a company sale, any share rights should ideally be exercisable before the acquisition is completed. This is because the shares may lose their status as qualifying shares for corporation tax relief if the company ceases to be independent.

[1] see Glossary. A Share Incentive Plan Trust, unlike a discretionary trust, holds shares for the benefit of named employees but this is subject to conditions set out in the trust deed, scheme rules and employee share agreements.

[2] Also known as a scrip issue or a capitalisation issue. see Glossary.

[3] Distributable reserves are, very broadly, the accumulated profits of the company. In a private company bonus shares can also be paid up from the proceeds of a fresh issue of shares or following a capital reconstruction sanctioned by the court.

[4] This summary is not intended to be a replacement for the full text of the guidelines, a copy of which can be obtained from the Association of British Insurers, 51 Gresham Street, London, EC2V 7HQ, telephone 020 7600 3333.

[5] Strictly interpreted this would seem to discourage the use of share options but we understand that this is intended to refer to highly artificial arrangements and not to conventional awards of shares or share options.

[6] We understand that these limits refer to the amounts granted, less any amounts that become incapable of vesting.

[7] We understand that this position is under review.

[8] Options capable of being exercised over a period of more than 10 years were once termed “long options” and potentially subject to tax on grant, but this is no longer the case.

[9] This curious “rule” may be intended to encourage companies to provide at least part of the value of the award in quasi-dividends rather than all in shares, thus reducing total dilution.

[10] This is significantly more restrictive than the “close period” (see Glossary) imposed by the London Stock Exchange Model Code for Directors’ Dealings

[11] Other than in exceptional circumstances such as the proposed flotation of a subsidiary.

[12] An “under water” option is where the exercise price to acquire the shares under option is more than the fair value of the shares. In these circumstances, there may be little if any remaining incentive, so the employer may wish to issue replacement options or attach a lower exercise price to the existing ones.

[13] The Pre-Emption Group, Financial Reporting Council, 5th Floor, Aldwych House, 71-91 Aldwych, London WC2B 4HN

[14] It is common practice to offer employees a priority allocation of shares if they are being offered to the public by way of flotation. This may well prove to be less than the market price after the offering. Provided not more than 10 per cent. of the shares being offered are made available to employees the benefit of priority allocation will not normally attract a tax charge, but any discount to the offer price will be subject to income tax.