Growth shares 101: 'Need-to-knows' for UK startups | Ledgy

Companies scaling and expanding in the United Kingdom are lucky enough to have a number of different employee share schemes in which they can participate. Growth shares are a popular option for scaling companies.

A growth share plan gives employees the chance to own a piece of the business and feel real alignment with the company's mission and vision. In addition, team members benefit from tax efficiencies on exit.

But should you choose to set up growth shares over, for example, an EMI scheme? And how should you communicate with the team about the ins and outs of growth shares? Let’s see how growth shares work for scaling UK companies.

What are growth shares?

{{quote-1}}

As with other employee equity schemes, growth shares are a way for companies to attract, reward, and motivate the top talent they need to achieve their goals. In addition, the hurdle price ensures that existing shareholders are not diluted by growth shareholders until the value of the company (represented in the share price) moves past a pre-established milestone.

What is a growth share scheme?

A growth share scheme is a tax-advantaged employee share scheme for UK-based companies. Growth share schemes are not one of the share schemes that need to be approved by HM Revenue & Customs (HMRC), the UK's tax authority. As we'll see, that gives companies setting up growth share schemes flexibility, with other consequences for tax liabilities depending on the company's exit.

Growth shares vs EMI options

Enterprise Management Incentive (EMI) schemes are perhaps the most popular method of granting equity to employees in early-stage UK companies.

EMI and growth shares differ in several important ways. For instance, did you know that unlike other employee share schemes, there are no restrictions on the total value of growth shares you can award to your team? And that unlike EMI options, growth shares aren’t limited to full-time employees?

{{usecase-cta}}

Higher capital gains tax on growth shares

Growth shares and EMI options are significantly more tax efficient than unapproved employee share schemes. In both cases, proceeds from the sale of equity are taxed as capital gains, not income, meaning a tax rate of 20% rather than 40% or higher.

However, when employees sell the shares they’ve acquired through EMI options, they typically qualify for Business Asset Disposal Relief (BADR) – which was previously known as Entrepreneurs’ Relief – on their earnings. This reduces the capital gains tax from 20% to 10%. BADR isn't normally a viable option with growth shares. This means that the owners of growth shares will pay capital gains tax of 20% on the increase in the share price once the hurdle has been cleared.

20% is still significantly less than the 40% rate charged on shares gained through unapproved equity schemes, but it’s higher than the rate stakeholders pay under EMI.

Companies determine their own valuation in growth share schemes

Before you can issue EMI options, you must agree on a valuation with HMRC. Under a growth shares scheme, the company sets its own valuation price, typically based on the valuation at the last fundraising round. Cutting HMRC out of the valuation process can help you set up your share scheme faster. It also means you’re not required to agree on a valuation with HMRC before issuing shares or options.

Fewer restrictions on who qualifies for growth shares

EMI options are designed for young companies growing quickly. It’s common for companies to begin their employee share scheme by issuing EMI options, and later move on to growth shares when they’ve hit one of the restrictions around EMI options.

For example, a company can’t set up an EMI scheme if it has more than £30 million worth of assets or more than 250 full-time employees. Certain industries are excluded too. In addition, the total value of the EMI options a company can give out cannot exceed £3 million. Only full-time employees — or part-time employees spending a certain amount of their working hours at the company — qualify to receive EMI options.

In contrast, growth shares offer more flexibility. Every company setting up a growth share plan must have a legal entity in the UK, but there’s no cap on the number of employees, the company’s assets, or how many shares can be issued. You can give growth shares to non-employees, including advisors and consultants.

Finally, EMI options have to be exercised within 10 years of granting, while there are no time limits on growth shares. This flexibility can make growth shares more viable for companies that don’t want to be constrained by the tight rules on EMI options.

Employees who own growth shares are shareholders

EMI options are not shares: they represent the option to buy shares at a fixed ‘strike price’ at a future date. Growth shares are shares. Once those growth shares vest, those employees become shareholders straight away.

However, unlike other share classes, people acquiring growth shares do not automatically have voting rights on company decisions. Also, if the worst happens and the company is forced to sell its shares at a low price, employees with growth shares will be forced to sell their shares at that low rate—while being liable for CGT based on the price they originally paid.

Unlike with EMI options, there is no vesting period for growth shares, since they are granted immediately. However, growth shares can be conditional — meaning an employee can be forced to return them — or unconditional. Some companies introduce a cliff at which the shares switch from conditional to unconditional.

Although you can, in theory, take back conditional shares if an employee leaves, depriving employees of shares they have earned undermines your equity scheme. Ledgy recommends allowing employees who leave on good terms (likely the majority) to keep their shares, i.e. to make them unconditional.

Our infographic sums all the key differences neatly:

You can download the full infographic here.

Growth shares and hurdle pricing

A very important feature of growth shares is the hurdle, which can have a big effect on how much someone’s growth shares are worth.

The hurdle is the price the share has to clear before employees can realise value from those shares. The board is free to determine the company’s hurdle price for its growth shares – there are no restrictions on how the hurdle should relate to the market value of the shares. Often, the hurdle is set at market value at the time of issue, or slightly higher. However, there are examples of companies who set very high hurdles, which only reward employees for their contribution if the company’s value increases by a huge amount.

Here’s a fictional example. The share price of a food delivery app called BigFood is 50p. Sarah, a BigFood engineer, is issued growth shares with a hurdle of 60p. If the company’s share price increases to £1 per share, Sarah has cleared the hurdle and her net gain per share is 40p — the difference between the share price and the hurdle.

However, say Sarah’s hurdle is set at £1.50 a share. Even if BigFood’s share price doubles in value to £1, she still hasn’t cleared the hurdle, so she isn’t entitled to any gains from her growth shares. This is an unfair and unproductive use of the hurdle.

Of course, companies may also be concerned about the dilution of the existing share pool. Setting a high hurdle price often does lead to less dilution than a low hurdle. But the purpose of an equity scheme is to reward your employees with a piece of the company they helped build and grow. This isn’t just a symbolic gesture: it has to reflect the monetary value they have added.

If you choose to issue growth shares, use scenario modeling and projections to set a reasonable valuation and hurdle price. And crucially, prepare to explain to the company why you’ve set the hurdle at that level, and set out what it might mean for employees at different exit milestones – £10 million, £100 million and £1 billion, say. This will help build trust in your equity scheme from around the business.

Pros and cons of a growth share plan

Let's sum it all up. Here are the pluses and minuses of a growth shares scheme.

Pros

• Growth shares offer more flexibility for slightly larger companies who have outgrown an EMI option scheme. There are no limits on the gross assets of the company, nor on the number of people the company employs. Growth shares can also be awarded to contractors and advisors, unlike EMI options.
• Growth shares are more tax-efficient compared to unapproved share plans where any profit is treated as income tax. Holders of growth shares will likely pay capital gains tax of 20% on the profits from their ownership stake.
• Growth shares are easy to set up and don't need HMRC to agree on a company value – the board can decide on a valuation without the tax authority getting involved.

Cons

• Tax on growth shares is not as efficient as EMI options. In particular, if it's decided that employees have paid under market value for their growth shares, they may have to pay income tax and national insurance contributions on the discount they receive.
• Growth shares often have a hurdle which can prevent employees from automatically seeing any benefit from their equity stake until the share price has increased beyond a pre-established milestone.

Get your team on board with growth shares

Growth shares are a great way to transition away from EMI options if your company is about to outgrow its EMI scheme. It's worth remembering that growth shares offer tax incentives for employees. However, it's essential to take the time to walk your team members through how growth shares work, especially factoring in the payout and tax implications of the hurdle price.

FAQs

What are performance shares, and how are they connected to growth shares?

Performance shares are similar to growth shares, but the shares vest (giving the holders full economic benefit) on the fulfilment of specific performance conditions. These can vary from company to company, and could be related to revenue targets, share price growth, or something else.