FAQ: Growth shares – how do they work? 

Many growing businesses offer employees share options or shares in the company they work for, both to attract and retain talent and as an incentive to allow them to benefit financially from its success.   

Growth share schemes are one way to do this and are often used where tax advantaged arrangements like Enterprise Management Incentive (EMI) or Company Share Option Plan (CSOP) arrangements cannot be used. Growth share schemes are an alternative way for your employees to benefit if the company grows in value after they receive the shares.   

The following FAQs answer the most common questions that arise when growth share arrangements are put in place. Our Employee Share Schemes solicitors are also on hand to advise your business on designing and implementing a growth share scheme. 

What are growth share schemes?

Growth shares schemes are a means by which companies incentivise senior employees and consultants.  

When an employee or director acquires a company’s shares, they need to pay market value for those shares or pay income tax on the discount to the market value (i.e. the market value less the amount paid). For all but start-up companies this could mean that employees will need to pay considerable amounts to acquire a company’s shares. Growth shares provide an efficient way of offering shares to employees because they are designed to reduce the market value of the shares at the time they are acquired by the employees meaning that the recipient shouldn’t pay a significant amount of income tax when they receive the shares or need to find cash to finance the purchase of ordinary shares. 

Growth shares are a special class of shares designed to have a low acquisition value. This is often achieved by restricting the growth shareholders to only benefit from an increase the company’s value from the date the shares are issued (often plus a small premium). So, if the company is worth £5,000,000 when it issues growth shares to an employee, the employee will only benefit if the company grows above (say) £5,500,000 in value, known as the ‘hurdle’ value.  

From the founders’ perspective, growth shares are a good way to retain the pre-existing value of the company while giving employees an opportunity to benefit from future growth. If they work hard, and the company grows, the employees get to keep any corresponding increase in the value of the shares they hold. 

Growth share schemes work particularly well where founders are looking to exit and alternative tax advantaged share option arrangements are not available.  

How do growth share schemes work? 

As an example of a growth share scheme, let’s say you own a company with 5 employees, and are looking to exit in 3 to 5 years. You’re aware that your pay levels are below a broader market rate but the business does not have cash to pay salaries at the highest levels.  

You’re thinking of setting up an employee share incentive scheme, but tax advantaged arrangements are not available and if you offer shares outright your staff will have to find the cash to pay the income tax that would attract.  

If, as in the previous example, the company is worth £5,000,000 and you give away 10% of the company in growth shares, the arrangements can be structured so that there should be a minimal tax or cash cost to pay at the time employees acquire the growth shares.

It is also possible to do financial modelling to adjust the hurdle where the upfront cost is too high to increase the hurdle to a level at which the share is affordable but also operates as an incentive (in other words it’s not so far out of the money it loses its incentive effect).

Assuming the hurdle is set at a 10% premium to the current value of the company, the shares will only start to be worth anything once the company’s value exceeds £5,500,000.  

If your five employees work hard and when it’s time to sell the company it is worth £10,000,000, you will be entitled to an amount equal to the hurdle (£5,500,000), and you will share the remainder (£4,500,000) 90:10 with the employees.  

What are the different types of growth share scheme?

Companies use growth shares to reward and incentivise key members of staff. Staff are able to purchase shares in the company without having to pay the full market value of ordinary shares. 

Growth

Growth shares are shares that are designed to only provide a financial benefit to the holder of those shares if the market value of the company increases after the date the shares are issued.  So, if the ordinary shares are worth £10 per share when the growth shares are issued, then the holder will only receive a benefit if ordinary shares are worth more than £10 on exit.

Hurdle

Hurdle shares are similar to growth shares but are designed to benefit the holder if the market value of the company increases beyond a set amount over and above its market value at the time the hurdle shares are issued. So, if the market value of the company’s shares is £10 each at issue, and the hurdle is set at £12 per share, the holder will only benefit if ordinary shares are worth £12 or more on exit.

Flowering

Flowering shares are a type of growth shares that only benefit the holder if certain performance conditions are met, for example if the company achieves a certain level of profits. Sometimes these arrangements enable participants to share in value below the performance condition, if the condition is met. In this case, the share will be more expensive on acquisition.

What are the pros of growth share schemes? 

• As growth shares have little real value when they are issued, and are a special class of share, your existing holdings and that of any other shareholders are not diluted financially until the value of the company exceeds the hurdle.
• They are a tax-efficient way of rewarding employees. Because of their low market value the shares are cheap to buy or only attract minimal income tax (and potentially national insurance) charges on acquisition. Any increase in value after acquisition should be treated as a capital gain.
• They can be set up with restricted voting, dividend and other rights that attach to ordinary shares. The company can also require that they be given up if the employee leaves.
• Capital gains tax will be payable on any increase in value of the shares, but these rates are generally lower than higher-paid employees’ marginal income tax rates.
• You can give staff dividends, unlike share option arrangements.

What are the cons of growth share schemes? 

• The tax advantages of growth shares depend on there being no changes in tax treatment or in the relative rates of income and capital gains tax.
• Growth share schemes are usually only suitable for private limited companies that can have more than one class of share, who are already successful and there is a reasonable prospect for future growth.

There are some administrative burdens and costs relating to growth share schemes for the company: 

• The company’s Articles will need to be amended, new shares issued, and filings made at Companies House.
• The company will need to ascertain its market value and the value of the growth shares by engaging a share valuation specialist.
• Growth shares work best where the company can expect to grow within a reasonable time and thus offer a substantial benefit to employees.
• The interaction between growth shares and the Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) needs to be carefully managed.

How do I create a growth share scheme? 

Qualifying criteria 

There are no qualifying criteria to create a growth share scheme. 

Process to set up a scheme 

Here’s how you set up a growth share plan: 

• Obtain a robust valuation of the company and the growth shares by an expert valuer. This is critical or otherwise you risk the valuation being challenged as part of a due diligence process on a transaction.
• Obtain your other shareholders’ agreement to the amendment of the Articles and issuing of new shares. 
• Amend your company’s Articles to create the growth shares and describe their rights in relation to other share classes, including leaver provisions and other terms designed to protect the company and its shareholders.
• Enter into a growth share subscription agreement with the relevant employees and issue the growth shares. 

What are the main characteristics of growth share schemes?

Right to capital

The holders of growth shares won’t receive anything when the company is sold unless the hurdle amount has been reached.

Right to receive dividends

The holders of growth shares may receive dividends; this is a commercial decision and also has valuation and cost implications.

Right to vote

Again, growth shareholders won’t get a say in the company’s affairs unless you set them up that way.

Leaver provisions

Normally employees who have been issued growth shares will have to offer them back to the company if they leave. You can set the conditions of sale at the time you issue the growth shares, and this may depend on whether the employee has left on good or bad terms.

How do you value growth shares? 

The initial value of growth shares should be considerably less than the value of an ordinary share even though there will be some value in the share at acquisition and HMRC expect this. 

You’ll need to demonstrate this by getting a valuation of the growth shares done when you issue the shares.

What is the hurdle on growth shares?

The hurdle is effectively a financial performance condition which must be met or exceeded for the holder of the growth share to get a financial return on their growth share.

Can growth shares receive dividends?

Growth shares can have dividend rights, although this can make the operation of the growth share scheme more complex. If growth shares do have dividend rights, the shares must be valued taking into account the potential income stream relating to the dividends which may make the shares more valuable at acquisition. This in turn may mean that the hurdle needs to be set at a higher value to reduce the purchase price at acquisition. 

How often may growth shares pay dividends?

This will depend on a number of commercial and legal considerations including the design of the scheme and whether the issuing company has sufficient distributable profits to pay dividends.

Is it better to extract value on the share through a sale or liquidity event or through a dividend?

Under current rules and rates, from a personal UK tax perspective, it will be more efficient for managers to extract value through a sale of the growth shares at capital gains tax rates (currently 20%), compared to dividends (currently taxed at a top rate of 39.35% on UK taxpayers in the additional rate band).

Can I set up an EIS or SEIS scheme as well? 

If the company has raised funding under an investment scheme such as the SEIS or the EIS and wants to issue growth shares, it may risk losing the tax reliefs available under those schemes. This is because SEIS and EIS shares cannot be issued at a preference in terms of dividends or on a winding up. Consequently, growth shares need to be structured carefully to operate alongside SEIS/EIS. 

What’s the difference between growth share schemes and other incentive schemes  

With a growth share scheme, a company can issue shares to employees immediately, without any significant amount of income tax being payable by the employee when they receive the shares. 

What are the alternatives to a growth share scheme?

There are other share option schemes which are outlined on our Employee Share Schemes and Equity Incentives website page. You can also find out more about employee share incentive schemes in this article.