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Share Valuation: is your business an elephant or a giraffe?

Posted on October 12, 2012

The headline grabber about new employee-owner contracts has attracted much commentary, including the observation that an employee would need to make an individual gain in excess of their current £10,600 annual Captial Gains Tax (CGT) exemption allowance before any additional tax relief benefit was felt under the new proposal. Of course an individual is sometimes permitted to transfer some of their shares to a spouse or civil partner and then their personal CGT exemption can be used also. Furthermore, except in the case of a sale of the business, shares can be divested over a period of time, thus an employee might choose to sell in tranches to make regular use of the annual CGT exemption to ensure no tax charge arises.
What we then realise is that there needs to be some significant share growth and/or a cliff sale event if the gains realised are ever to be liable to CGT. This might well explain why the employee-owner contracts have been promoted as being particularly relevant to smaller, fast growth, entrepreneurial businesses, albeit all businesses will be able to use the new contract model.
We have also observed that the employee-owner share awards are not exempt from income tax or national insurance and therefore an up-front tax charge may arise where shares are acquired for less than market value. That's market value in the eyes of HMRC.
Clearly share valuation is a relevant consideration here and the attraction of these new employee owner shares may largely depend on the share value growth potential. 
Entrepreneurial companies tend to follow a distinctive "giraffe-like" growth pattern. The ambition of such business owners is to maximise share value over a short time frame. Their offering may be very much of the moment and there may be just a very short window of opportunity to maximise first mover advantage, generate market leader revenues and then negotiate a trade sale to a strategic acquirer. Their share value pattern may look like this: 
Employees who are recruited whilst such ventures are in their formative early years can acquire equity whilst there is little entrenched value and then reap significant gains when the ultimate exit materialises. Their tax charges can be minimised but a very large exit value can still land them with a hefty CGT bill. The lure of a total CGT exemption might therefore appeal to this demographic but will such employees be happy to sacrifice employment law rights in exchange?
More established businesses will have a potentially significant share value already and therefore employees acquiring equity in those employer companies will be keen to ensure discounts can be agreed with HMRC to negotiate a market value acquisition price that is affordable and to ensure that any upfront income tax charge arising in respect of free or discounted share awards (potentially for example under the terms of these new employee-owner contracts) is minimised. If the business is quoted on a stock market then the market has established the pricing and discounting factors available to private companies will not apply. 
Such businesses owners may not have any ambition to sell. They may wish to preserve the trading of the business as an independent business that is owned in perpetuity by its employees or any sale plans are so distant as to have no impact on employee behaviour. The business may have already passed its peak growth stage and is experiencing stable performance with slight growth forecast. Such businesses might have a share price value pattern that looks more "elephant-like" like this:

With no cliff exit event and lesser share value growth potential, employees of these businesses may feel no compulsion to seek further CGT relief and instead find that their tax position can be sufficiently protected by receiving their awards within existing approved share plan frameworks; providing of course the share valuation means adequate awards can be made within the plan limits. The expertise and experience of a specialist share valuer can therefore help with the modelling of equity levels and it is worth noting that even if a valuation formula is stated in the company's Articles of Association this is not necessarily going to produce a result that HMRC would agree for tax purposes.  

If equity is transferred to employees it is essential to agree the share market value for tax purposes with HM Revenue & Customs. This can be agreed in advance for all approved share schemes to avoid any surprise tax bills! When negotiating the share value for private companies it is necessary to have regard to the commercial outlook and future earnings potential and here a glass half-empty perspective, asking owners to be candid not only about success but also identifying the challenges and threats, is important.
If you are looking at making share awards to employees it is worth seeking professional advice; to not agree a value with HMRC is opening the participants up to a whole raft of unexpected tax! Details of our share valuation services can be found here and you can download a fact sheet here.
You can contact the RM2 team for advice and quotes on valuations and more widely implementing a share scheme on 020 8949 5522. 

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