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Start-Ups: using equity to build teams

Posted on June 02, 2011

Many entrepreneurs find starting up in business hard and lonely. A key problem is assembling a quality team at a time when the future is uncertain and cash is in short supply.

Increasingly, start-up entrepreneurs (and their backers) are turning to equity based incentives. These allow companies to attract key employees without matching the salary and benefits packages of more established competitors. The upside potential of an employee share option is potentially unlimited, and since there is no obligation to exercise, there is no risk to the participant. Share options carry a cost in terms of dilution but if correctly designed the cost will be more than offset by enhanced growth in overall business value.

There are several schemes available. Very popular is the Enterprise Management Incentive (EMI) which is a government backed scheme introduced specifically for smaller entrepreneurial businesses. The employee is granted the option to purchase company shares in the future at an exercise price set at the date of grant. The employee gains when the value of the shares rises above the exercise price. Shares will typically be sold on an exit, such as a trade sale or flotation. Other possible structures include the Deferred Share Purchase Plan (DSPP) and Joint Share Ownership Plan (JSOP).

Gains resulting from an increase in the value of the underlying shares are subject to Capital Gains Tax (CGT) only, with a maximum rate of 28%. This is much better than the crippling income tax and NI charges on unapproved options which can total well over 50%.

Spin-out companies

But why not just give the employees some shares? A new start-up may have very little intrinsic value. And indeed, HMRC does not normally seek to levy tax on shares acquired by individuals directly at incorporation, providing that: (i) the only securities acquired are shares; (ii) all the shares are acquired at nominal value; and (iii) the subscriber will be a director of the company in question. Clearly, this exemption will not apply if the company has already acquired specific value before the shares are issued.

A special problem arises however with so-called spin-out companies, set up to exploit intellectual property (IP) transferred to them by universities or other research institutions. Once the IP is transferred, the shares acquire value. If shares are then gifted to an employee, this will represent a benefit in kind. And, until December 2004, that value was taxable.

Fortunately, the position now is that, subject to certain conditions, the value of IP transferred is ignored for income tax purposes, so that all gains are within the CGT regime. To qualify for this treatment the recipient must be engaged in the research activity, and the shares must be acquired within 183 days of the IP transfer. Where the IP will be transferred in stages, the agreement should be drafted to ensure that relief on all stages is obtained. In some cases, the value of the shares may reflect commercial factors other than the IP transfer and in these cases professional valuation advice is essential.

For more information on using equity in start-ups please contact us on 020 8949 5522 and ask to speak to any one of our advisers.

 
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