Share capital considerations

The design of an employee share scheme will normally involve decisions in relation to the shares to be used and the rights attaching to them. 

Using non-voting shares

The simplest arrangement is for a company to use its existing ordinary shares for the purposes of the scheme. However, there may be concern that this would alter the balance of voting control. In such a case non-voting shares can be used. Non-voting shares can be used in all the statutory schemes. In the case of an Approved CSOP Scheme or Approved SAYE Option Scheme a new class of non-voting shares will need to be created, and a free issue of shares of this class given to the existing ordinary shareholders. The free issue (sometimes known as a “bonus” or “scrip” issue) is to satisfy a regulation that the majority of the shares of any class is owned other than by employees who acquired them through an employee scheme. This regulation is imposed to help ensure that the employee shares are “worth having”.

For the Share Incentive Plan and the Enterprise Management Incentive, a new class of non-voting shares can be issued without the need for a prior free issue to existing shareholders.

Use of shares in subsidiary companies

Subsidiaries of private companies cannot use their own shares to establish a statutory employee share scheme, but as mentioned on page 17 it may be possible to circumvent this using a special class of shares in the parent, perhaps linked to customised vesting arrangements.

In certain circumstances, subsidiaries of listed companies can use their shares for statutory schemes (except the Enterprise Management Incentive). However the listed parent must not be a close company (see Glossary) or a company that would be close if it were domiciled in the UK. In the case of an Approved SAYE Option Scheme or CSOP scheme, the capital of the subsidiary company must consist of a single class of shares only.

In practice the use of subsidiary shares by listed companies for employee schemes is rare. This is because the UK stock exchange regulations require approval by the shareholders of the listed parent for any such use of subsidiary shares, and the practice is also frowned on by the Association of British Insurers. The alternative of creating a separate class of shares in the parent to reflect the performance of the subsidiary will generally not be practical for listed companies.

If employee incentives are offered in the shares of a subsidiary of a private company, the value of the benefit will not attract corporation tax relief. In order to be qualifying shares for this purpose, the shares must be shares in an independent company or the subsidiary of a listed company.

Loss of rights on leaving employment

Many employee share schemes are designed to encourage employees to stay with the company. Employers may therefore wish to ensure that if employees leave within a certain period, either of their own volition or because they have been dismissed for some offence, they should lose their rights to the shares.

Loss of rights can be enforced under all the statutory schemes. Under the Share Incentive Plan, an employee who leaves within a period of up to three years of receiving the shares in trust can be required to forfeit them, unless the employee is a “good leaver”. A good leaver, broadly, is one who leaves for an involuntary reason such as illness, disability, redundancy or retirement. Under any of the Government regulated option schemes, (including the Approved SAYE Option Scheme) employees who are not “good leavers” can be made to forfeit their rights if they leave before exercise of the option concerned. 

There will also be occasions where an employee has acquired shares, and then leaves. Most private companies wish to prevent departing employees from taking their shares with them. In these cases, the articles of association of the company can require that departing employees are forced to sell. The shares can then be purchased by the other shareholders of the business, by an employee trust or by the company itself. The terms on which the shares are to be sold must be laid down in the articles. These terms need not (and usually do not) specify a particular price but instead set down a formula or method for determining the price. Often the auditors will be called upon to reach a determination. It should be noted that if a rule requiring sale is introduced in accordance with a statutory scheme (other than EMI), all employee shareholders including any working proprietors of the business will be bound by this rule, and all those selling shares of the same class will be obliged to do so on no better terms.

Other restrictions on shares

Apart from the above permitted restrictions, in relation to voting rights and the treatment of leavers, the shares used in a statutory employee share scheme must not have rights that are more restricted than the other shares of the same class (other than an EMI scheme, where restricted shares can be used). In Share Incentive Plans, the rights must not be more restricted than any other class of ordinary share capital. 

This can create problems where, for example, a private company has issued shares with special rights to one or more investors, or where certain actions can be taken with the agreement of a stated majority of shareholders. Because of these special rights, the shares used for the employee scheme may be regarded by HM Revenue & Customs as restricted by comparison with the shares held by the larger shareholders. It is usually possible to correct this problem, for example by issuing a new class of share for the employee scheme that is not restricted in relation to the investors’ shares. In other cases, a capital reconstruction may be required, so that the investors’ special rights are held in securities that do not form part of the ordinary share capital. Where, however, there is a complex shareholders’ agreement, hammered out through long negotiation, it may be impractical to obtain the agreement of the shareholders to such radical changes.

HM Revenue & Customs takes a strict line in this area. For example, if the articles contain a rule that a vote of 95 per cent. of the shareholders can permit the unrestricted transfer of a share, HM Revenue & Customs will deem that shares of that class cannot be used for a statutory employee scheme (other than EMI) because the holders of the remaining 5 per cent., who could include the employee shareholders, would have restricted rights by comparison. This is despite the fact that, even if there were no such provision in the articles, a 75 per cent. majority of shareholders could achieve the same effect by passing a special resolution under ordinary principles of company law.

Before making an application for any statutory scheme it will therefore be important to examine very carefully the articles of association, and any shareholders’ agreement. Professional advice should be sought.

Financial assistance

The Companies Act 1985 contains a general prohibition on companies providing financial assistance to purchase their own shares. This is to prevent companies using shareholders’ money (or finance raised against their assets) to manipulate the value of their own equity. However in a consultative paper on Company Law reform published by the Department of Trade and Industry in March 2005, it was proposed that the prohibition on financial assistance should be abolished for private companies.

There is an exemption in the current rules if the financial assistance is provided for the purposes of an employees’ share scheme, as long as the assistance is given in good faith in the interests of the company. An exemption is also available when financial assistance is provided for the purposes of creating or maintaining an internal market in a company’s shares, for example through an employee benefit trust or the purchase of treasury shares. Additionally, companies are permitted to offer loans to employees (other than directors) for the purposes of acquiring company shares. 

Both private and public companies (whether quoted or unquoted) can take advantage of these exemptions but public companies may only do so if the financial assistance provided either does not reduce the level of net assets or, to the extent net assets are reduced, the financial assistance is funded from distributable profits. This has an unfortunate interaction with the UITF abstract 38, issued by the Accounting Standards Board, which requires that the value of shares held by an employee trust must be shown as a deduction from net assets.

Take-overs

All the statutory schemes provide that, if the sponsoring company is sold, existing scheme benefits can be “rolled over” into rights over securities in the acquiring company. The market value of the securities and the rights held by the employees over those securities must be effectively the same as before. This would include for example good and bad leaver regulations and any vesting schedule. For tax purposes the new rights will then be treated as if the old rights had continued without interruption. This allows for the various time periods attached to the various scheme to continue running uninterrupted: the Holding Period in a Share Incentive Plan, business asset taper relief on options under a Enterprise Management Incentive Scheme, the savings contracts for an Approved SAYE Option Scheme and the 3 year minimum exercise period in an Approved CSOP Scheme.

For the Approved SAYE Option Scheme and the Approved CSOP Scheme, the new shares must meet the requirements satisfied by the original shares in terms of the eligibility of the acquiring company and the capital structure. However for the Share Incentive Plan the new securities can be in almost any form, including loan notes and preference shares. The new securities are held by the trustees as if they were the old securities and in due course distributed to the participants in line with the original rules of the scheme. The tax treatment is unchanged.

Options granted under the Enterprise Management Incentive can also be exchanged for new options in an acquiring company, providing that:

If all these conditions are satisfied then business asset taper relief will continue to run from the date of grant of the initial option.

Normally, a company cannot offer EMI options if it has gross assets of more than £30 million or owns any subsidiaries as to less than 51 per cent. . However these restrictions do not apply to a company issuing replacement options.

[102] Note that the rights must be the “same” not “similar”. Therefore even minor differences are likely to disqualify the acquiror’s shares and in cases of doubt clearance should be sought from the Small Companies Enterprise Centre.