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Using HMRC Valuation Methods to Boost Employee Rewards

Posted on September 21, 2010

The benefits of employee share schemes are well known. In addition to being a proven tool for retaining and motivating employees, they can also offer large tax savings and help conserve cash.

Increasing numbers of private companies are using the schemes to help focus employee attention on building shareholder value ahead of a sale or flotation of the business. All these incentives involve a degree of dilution for the proprietors: there is a trade-off between the "cost" of this dilution and the benefits of creating greater value in the company for the benefit for the shareholders as a whole.

The way in which the company share valuation is undertaken is crucial. Give away too many shares too cheaply, and equity is wasted. Offer an incentive that is too limited in scope, and equity could be wasted again: the dilution is incurred but the incentive may not have the desired effect.

HMRC to the rescue

Here, fortunately, HMRC comes to the aid of private companies. The value HMRC will agree for small holdings of private shares is very conservative - typically a quarter or a fifth of the value that could be expected for the same shares if they were quoted on a public investment exchange. This means that companies offering share schemes can, if they choose, offer an immediate endowment of benefit to the participants. Looked at another way, they can provide a targeted level of benefit with at a much smaller cost in terms of share capital dilution.

How does this work in practice? Consider a company offering a straightforward option under an Enterprise Management Incentive scheme. Suppose that if the company were sold tomorrow it would fetch £1.00 a share. As a very broad generalisation, HMRC is likely to agree a "fair market value" for the unquoted shares of around 20p to 25p, just on the grounds that they are not quoted. This means that, if the options are granted with an exercise price equal to HMRC's "fair market value", the employee is being given the opportunity to acquire shares at a discount of 70 to 80% Of course all companies are different and different valuation considerations may apply in individual cases.

Bigger gains, lower costs

Therefore, even if there is no increase in the company's value at all prior to the exit event, the employee stands to make a substantial profit from an option granted at "fair value". Alternatively, the company can provide a given level of benefit at a much lower cost in terms of dilution than would otherwise be the case.

Normally, gains on employee share options are subject to income tax and NICs, which will leave a nasty dent in the net proceeds. However in this example, the scheme being used - the Enterprise Management Incentive - is a government sponsored scheme and any gains realised by participants are subject to capital gains tax, not income tax. The gains are also free of National Insurance Contributions, both for the company and the employee. All the gains made by the employee in excess of the low "fair market" value agreed with HMRC benefit from this treatment.

For some companies, this means that employee share schemes can be offered as a partial or complete replacement for cash. For example, one of our clients recently offered its key employees this choice: a £20,000 cash bonus now, subject to income tax at the highest rate and NICs, or a share option with an embedded value of £20,000, being the difference between the exercise price at fair value and the likely commercial value of the shares. Employees who opt for the option will get a much lower rate of tax on their rewards. They also have the opportunity to benefit from any increase in the value of the shares over the period prior to exit. However, employees considering the share option alternative will also need to bear in mind that their rewards will be deferred until the exit is achieved, and there is always the risk that the company's shares might decline in value.

If you would like to discuss this in greater detail, please contact us now on 020 8949 5522 and ask to speak to any of our advisors.

 
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