Choosing the right scheme

Clarifying company objectives

When considering the introduction of an employee share scheme, the Board (or, in larger companies, the Remuneration Committee) should consider carefully the objectives of the scheme and its implications for corporate strategy, corporate structure and, for private companies, succession planning. Sometimes directors within the same firm will have divergent views on these matters and these differences will need to be resolved before a share scheme can be designed.

Common reasons for introducing a share scheme are as follows:

Attracting and retaining key staff

Most companies considering an employee share scheme are mainly concerned about the recruitment, retention and motivation of selected key staff. The provision of equity incentives to these individuals is normally achieved through the offer of shares or share options. The offer itself may be conditional on performance, or more usually, the ability of the employee to obtain benefits from the scheme will be linked to performance. The performance conditions may relate to corporate, departmental or even personal achievement. 

Sometimes companies may wish to provide incentives to individuals who are not employees. Care should be taken that this does not result in the scheme ceasing to be an employees’ share scheme within the meaning of section 743 Companies Act 1985, since bona fide employee schemes carry a range of special advantages. These include special exemptions from the requirements of the Companies Act in relation to shareholder pre-emption, the authority of directors to allot shares and the provision of financial assistance for the purchase of the company’s own shares.

Improving staff morale and commitment

Many companies also wish to improve the level of team spirit and motivation of staff across the board. These companies should consider a scheme that allows all employees to become “stakeholders” in the business. 

A common arrangement is that all the employees of the company receive a (small) gift of shares, the size of which may be related to salary, length of service, hours worked or other factors. From this point forward, all employees have a direct personal interest in the success of their company. For tax reasons such schemes are usually offered under an Approved Share Incentive Plan.

Alternatively, an all-employee share option scheme may be considered. These schemes are usually offered so that employees benefit only if the value of the shares rises – either through improved company performance, or perhaps through a sale or flotation. However, it is also possible to include an element of gift in such arrangements. This can be achieved by granting the option with an exercise price less than fair value, or even nil.[15] This means that the option has a clear positive value from the date of grant but the value is not subject to tax until the option is exercised.

In a private company, there is often an element of bonus even if the options are granted at an exercise price equal to fair value. This is because HM Revenue & Customs usually agrees a low value for unquoted shares, since there is no public market for them. If however the company is later sold or floated, the real value of the shares is likely to be much higher.

An employer may also wish to provide an opportunity for all staff to purchase shares. This can help to reinforce employee commitment and the level of employee interest in the performance of the firm. If an Approved SAYE Option Scheme or similar scheme is used, the employee can be insulated from any investment risk.

Many younger employees now perceive a company share scheme to be a more attractive benefit than a company pension scheme. Both arrangements are tax efficient but employee share schemes can deliver benefits over much shorter periods. Of course, employees should not be encouraged to forsake pensions in favour of share schemes, since the latter cannot offer a proper spread of investment risk. 

Conserving cash

Many companies, especially smaller ones, need to conserve cash to finance growth. 

An employee share scheme can provide the promise of a valuable benefit, but defer the cost into the future. For example, it costs nothing in cash terms to grant a share option. The cost is deferred until exercise, which may not occur for some years. At exercise, there will be a cost in terms of dilution to the existing shareholders if the shares are sold on the open market. Alternatively, in a private company, the major shareholder(s) may offer to repurchase the shares, either directly or through a trust, in which case there will be a cash cost in respect of the repurchase. This may not occur until some time after exercise.

A company could achieve a similar result by promising a cash bonus in the future, the amount of which might depend on company or personal performance. However, promises to pay cash bonuses more than a short time in the future may be seen by employees as less tangible than a right to acquire shares in the business.

The offer of share incentives is a cost to shareholders, not to the company. Despite this, accounting standards now require the notional cost of share incentives to be expensed to the relevant company’s profit and loss account. For a fuller discussion see page 112.

Succession planning

In a private company, retiring shareholders can supply shares to employee share schemes and receive cash proceeds, without involving external investors or requiring existing investors to raise finance. In a small but growing number of cases, original shareholders are now arranging for their entire shareholding to pass to employees over time.

When retiring shareholders sell into an employee share scheme, they can normally expect to be taxed at capital gains tax rates with the benefit of business asset taper relief, usually reducing the effective tax rate to just 10 per cent. or less[16]. If the shares are sold into an Approved Share Incentive Plan, all the taxable gain can be rolled over into replacement assets. As long as these are within the capital gains tax regime no gains will crystallise on the initial sale of shares.

Tax saving

Statutory employee share schemes can offer substantial tax benefits, since the value of the shares awarded, or obtained through the exercise of options, may be wholly or partly free of tax. In addition, both employer and employee may save the cost of national insurance contributions that would otherwise be payable if the shares are readily convertible assets.

The tax-efficiency of an approved employee share scheme may substantially reduce the gross cost to the employer of providing a desired level of net benefit. The employer may then feel that additional funds can be applied to such areas as pensions, health insurance or other benefits, thereby further enhancing the attractions of the total benefits package.

The tax advantages of statutory schemes are so striking that some employers are tempted to introduce the schemes for the principal purpose of enjoying the tax savings. Directors should resist this temptation, since the purpose of the legislation is to encourage the introduction of bona fide employee schemes, not to provide tax breaks for their own sake. In addition, companies that are mainly motivated by the tax savings may become frustrated with the regulations imposed by statutory schemes, and the beneficial effects of the schemes in terms of employee attitudes may be diminished or lost.

Dilution of equity

The introduction of any employee share scheme will result in some part of the equity value of the business passing from existing shareholders to the employees. Owners of private companies, in particular, may be concerned that this will result in an erosion of ownership and control.

Rationally, shareholders will agree to the issue of equity incentives only if they believe one or more of the following:

In practice, most companies that introduce employee share schemes appear to do so because of a combination of the above factors. Private companies may also have the opportunity to repurchase shares from employees, thus effectively reversing the dilution albeit at a cash cost to the company. If the share scheme is a tax-efficient statutory scheme, the overall cost to the company may be significantly less than would be the case with a cash based scheme.

Directors sometimes have concerns about the implications of employee share ownership for shareholder control. These concerns are normally misplaced. In most cases the number of shares used in an employee share scheme represents a small proportion of the share capital. Unless the control of a company is finely balanced, the shares used for an employee will not disturb the status quo. Also, in practice, it is rare for employees to exercise their voting rights in unison, or indeed at all. Holders of share options do not have voting rights until they acquire shares through the exercise of the option.

Moreover, as noted above, the transfer of shares to employees need not be irreversible. A private company can create an internal market in its shares through an employee benefit trust and the shares repurchased by the trust can be recycled for use in future awards. It is also unlikely that shares in private companies will “leak” into the hands of third parties since there is generally very little appetite for small numbers of shares in private companies and the articles of association can contain rules to prevent sales to external buyers. 

In some private companies, the balance of control between different shareholders is important and the existence of even a small minority of employee shareholders could disturb that balance. In such cases, it is usually possible to create non-voting shares for the purposes of the employee share scheme. In the case of the Approved CSOP Scheme and Approved SAYE Option Scheme, the majority of any class of share capital used for the scheme must normally be owned by those who acquired their shares otherwise than through the scheme itself.[17]

When statutory schemes are unsuitable

Almost any company can operate a non-statutory employee share scheme. However as noted previously the benefits of most non-statutory schemes are subject to income tax at the individual’s highest rate, and may also be subject to national insurance contributions.

Most companies, whether large or small, quoted or unquoted, can also offer statutory schemes, subject to the rules and restrictions attaching to the individual schemes (see relevant sections of this Guide). However, directors should be aware that there are some circumstances where it may be difficult or impossible to introduce some or all of the statutory schemes, including the following:

Very small companies

The professional fees involved in establishing a statutory employee share scheme can be significant. In relation to all-employee schemes (the Approved Share Incentive Plan and Approved SAYE Option Scheme) companies with fewer than about 20 employees may not be able to justify the fees. However even very small companies should be able to afford simple share option schemes, including the Enterprise Management Incentive, provided there are no additional complications to be dealt with.

Companies that are not independent

If a private company is a subsidiary in a private group, the shares of the top company in the group must be used for the purposes of a statutory employee share scheme. The purpose of this regulation is to stop private groups gaining a tax advantage by manipulating the accounts of their subsidiaries. Possible solutions to this problem include:

Such arrangements could be regarded as artificial, however, and in this case they would need to be disclosed to the Anti-Avoidance Group of HM Revenue & Customs.

If the holding company is listed (see Glossary) or the subsidiary itself is listed, subsidiary company shares can be used for any statutory scheme except the Enterprise Management Incentive. For further details see page 85. Non-statutory share schemes can of course be operated in any shares, including subsidiary company shares.

Non-qualifying share capital

In all statutory schemes, only fully paid up, non-redeemable shares can be used. For all statutory schemes other than the Enterprise Management Incentive the rights attaching to the shares must not be restricted in relation to other shares,[18] apart from certain permitted restrictions, namely:

Further details of these and related issues are given under “Share Capital Considerations” on page 85.

Partnerships, charities and trusts

Employee share schemes cannot be offered by partnerships, since by definition they lack share capital. Some partnerships own limited companies, and provided such companies have share capital[19] they can operate employee schemes. The same principle applies to limited companies owned by charities or trusts. 

In principle a company owned by a partnership, non-corporate charity or trust can offer any kind of employee share scheme, including statutory schemes, but it should be noted that:

LTIPs

Since the Greenbury Report of 1995 there have been several public reports intended to improve ethical and business standards in British boardrooms. One result has been that larger companies have tended to move away from incentive structures that could be seen as tax driven or artificial. 

This may have contributed to a growing fashion for Long Term Incentive Plans (“LTIPs”). These take a variety of forms, including cash and nil-cost options, but a typical structure is that shares are gifted into trust for a senior employee or director, or simply reserved by the company, and released on the achievement of pre-arranged performance and/or loyalty targets. 

Under a bonus matching scheme, participants will give up some or all of their cash bonus in exchange for shares which are held for them in trust. The shares are only released if certain conditions are met, normally in relation to loyalty and/or performance. A typical loyalty period will be 3 to 5 years. If the criteria are met, the shares are released and are often augmented by additional free shares.

It is sometimes argued that share-based LTIPs are an attractive alternative to share options. LTIPs can be made subject to similar performance and loyalty conditions, but in order to transfer a given value to employees, fewer shares are needed thus causing less dilution of the share capital. This is because in an LTIP the whole value of the share is transferred, whereas the value of an option is simply the difference between the value of the share and the exercise price. LTIPs can also never be “underwater” (see Glossary) since shares can never be worth less than nothing. In practice, however, it is easy to design share option schemes with similar characteristics to an LTIP. For example, a share option with “cashless exercise” will deliver to the participant only sufficient shares to satisfy the profit on exercise. This is similar to the concept of share appreciation rights, where participants have the right to receive cash or shares related to the growth in the company’s share value over time.

If an LTIP is structured using new shares, then, as in the case of a share option, the company will be able to incentivise employees without suffering a cash cost. This may be important if the company requires the cash to finance growth or acquisitions.

The recipient of an LTIP normally pays full income tax on the benefit when received and there will also be employer and employee NICs if the shares are readily convertible assets (see Glossary). If the shares are sold and the proceeds are transferred into a self-invested personal pension plan, the recipient will receive income tax relief on the value of the transfer, thus offsetting the charge on receipt of the benefit. There may however be a significant timing difference between the collection of income tax through PAYE and the receipt of relief on the pension investment, which for higher rate taxpayers will be done partly through PAYE and partly through self-assessment.

Some companies have offered their employees rewards in the form of shares, the value of which was then artificially increased or decreased, perhaps by manipulating the terms of trade between group companies. Following ITEPA 2003 any such change in value of more than 10 per cent. which is due to “non-commercial” reasons is subject to income tax. This is charged in relation to the tax year in which the change occurred, whether or not any benefit was crystallised.

Where employees receive value in the form of shares the amount will be available as a deduction against the company’s taxable profits, provided certain conditions are met.

Other practical issues

Complexity and administration

The design of a successful share scheme will require attention to the relevant provisions of company law and tax law. Accountancy issues and trust law issues may also be involved, and unquoted shares will need to be valued. Especially if the scheme is a statutory scheme, with the associated tax advantages, it is important that the administration of the scheme is competently handled, with careful attention to detail to ensure that the tax advantages are not inadvertently lost.

In many smaller companies, the directors will have neither the time nor the expertise to handle these issues, and professional advice should be sought. This of course will result in professional fees, but a competent adviser will be able to introduce and administer a scheme in such a way that minimal involvement of management time is required. For a statutory scheme the cost of professional advice should be normally only a small proportion of the tax savings available. 

Confidentiality

Employees who receive a gift of shares, or who are permitted to purchase shares, will have the same shareholder rights as other holders of shares of that class. These normally include the right to receive copies of the company’s accounts. Some smaller companies are concerned that this could cause a loss of confidentiality. However, the accounts that the employees are entitled to see are no different to the accounts that are lodged at Companies House as a matter of public record. 

In our view, companies should make a virtue of providing information to employees on the performance of the business, wherever possible. This can be used as an opportunity to communicate with employees and reinforce messages about commitment and common purpose.

Employees who leave

A principal objective of many employee share schemes is to encourage loyalty. Most companies therefore wish to withhold benefits from employees who leave. A distinction is often made between “bad leavers”, that is, those who leave voluntarily or are dismissed “with cause”[20], and “good leavers”. In the Approved Share Incentive Plan and Approved SAYE Option Scheme, good leavers are defined as those who are forced to leave because of illness, injury, disability, retirement, redundancy,[21] death, or being forced to leave the employing group because of a transfer of part of the business to another group.[22] In other types of share incentive, the employer can define good and bad leavers as it wishes. In general, all the statutory schemes provide that “bad leavers” can be made to sacrifice some or all of their scheme rights.

The rules of any share incentive arrangement should make it clear that the incentive does not form part of the contract of employment. This is to discourage employees who are suing for wrongful or constructive dismissal from suing also for the loss of the value of their share incentives. However, it appears that there is no form of words that can provide complete protection to the employer.

The way in which good and bad leavers are treated under the statutory schemes can be summarised as follows:

Approved Share Incentive Plan: bad leavers can (at the employer’s option) be required to forfeit any Free or Matching Shares if they leave within a period, specified by the employer, of up to three years. They cannot be made to forfeit any Partnership Shares they have bought. Good leavers (as defined above) may retain all their shares and will pay no tax on their value.

Approved SAYE Option Scheme: those who leave before completing their 3 or 5 year savings contract and are bad leavers lose the right to exercise their option, but retain their savings. Some interest may be payable on the savings, depending on the length of the savings period completed and the rules of the individual savings carrier. Good leavers (defined in the same way as for the Approved Share Incentive Plan) can exercise their option to the extent possible with their accumulated savings at the date of departure.

Statutory Share Options: (the Approved CSOP Scheme and the Enterprise Management Incentive): the employer is free to define “good” and “bad” leaver and also the period of time during which any penalty for early leaving is imposed.

Under a non-statutory scheme, the employer can of course stipulate whatever rules it wishes. 

The situation frequently arises where an employee leaves, but not until after collecting one or more awards of shares through the company share scheme. This is generally not of concern in a quoted company, where shares are already held by members of the public, but most private companies prefer to restrict share ownership to founder members, employees and (where applicable) investors. It is a simple matter to amend the articles of association of a private company to require that when an employee shareholder leaves, the shares are offered for sale so that they can be repurchased by other shareholders, an employee trust or the company itself.[23]

There are many possible variations to this mechanism. For example, the terms available to the leaver may improve as length of service increases. Those who leave voluntarily may receive inferior terms to those who leave involuntarily. In some cases, if the ex-employee does not receive an offer at fair value for all the shares, he may keep the remaining shares, or keep them until the company procures an offer at fair value. As noted above, there are limits to the restrictions than can be placed on shares used for statutory schemes, apart from the Enterprise Management Incentive.

[15] If an option is issued with an exercise price less than nominal value, the company must pay up the nominal value either from distributable reserves or (if it has no such reserves) from the proceeds of a fresh issue of shares; otherwise, a more complex capital reconstruction may be required.

[16] There are certain grounds on which HM Revenue & Customs could in theory seek to attack this treatment. For details on how to minimise this possibility see page 78. It appears however that sales into a statutory SIP trust are immune from risk.

[17] In the case of a private company, this means that the majority must be owned by the proprietors or external investors. The purpose of the rule is to ensure that, in the eyes of HM Revenue & Customs, the shares are “worth having” (see also page 85, “Share capital considerations”).

[18] The shares used in a Share Incentive Plan must not be restricted by comparison to any other ordinary shares of the company; in a SAYE Share Option Scheme or Approved Company Share Option Plan they must not be restricted in relation to other shares of the same class. See also footnote 16.

[19] Rarely, a company may be limited by guarantee instead of by shares. This means that the owners have agreed to meet the company’s liabilities up to the limit of a guarantee provided by them, as opposed to the value of share capital subscribed by them. Companies limited by guarantee cannot offer employee share schemes and there is no mechanism in UK company law by which a company limited by guarantee can be converted into a company limited by shares.

[20] To be dismissed “with cause” means to be dismissed for a disciplinary reason specified in or implied by the contract of employment. It is important for all companies, even the smallest, to have in place proper contracts of employment otherwise expensive disputes may arise. Disciplinary procedures are normally incorporated in the staff handbook.

[21] Within the meaning of the Employment Rights Act 1996.

[22] Being a transfer to which to which the Transfer of Undertakings (Protection of Employment) Regulations 2006 apply.

[23] If the employee has held the shares for less than 5 years, a sale to the company (as opposed to another shareholder or employee trust), could result in a charge to income tax instead of a potentially lower charge to capital gains tax. It may be possible to circumvent this problem if the employee sells through an agent or third party. See page 78.