Companies often offer shares or options for shares to employees as part of their overall compensation package, and these are known as employee share schemes. As well as incentivising staff who may become part-owners of the companies for whom they work, share schemes often carry with them tax advantages.
If you are looking to acquire a business, the existence of an employee share scheme can become a potential hurdle in the process. That’s why it’s important to understand ahead of time if the business you’re buying has an employee share scheme in place, and how employee shares will be handled in connection with the purchase.
In this article, we explore the essential factors to consider, including the significance of understanding the due diligence process, employee share vesting and the tax implications, to ensure a smooth business acquisition.
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The importance of due diligence before buying a company
The main purpose of due diligence is to enable you to find out as much as possible about the target company so you can put a value on it, to identify any risks involved in the transaction that may affect that value or cause you to want to pull out of the transaction, and to give you information about the company culture and set-up so that you can operate it properly after completion.
Key details to collect during the due diligence process
When buying a company, it’s important to find out how many classes of shares and the number of shares (and options for shares) that exist, including whether any are held by employees, and the terms on which those employees hold their shares. You can find out this information from the company’s Articles of Association, the share scheme document and any shareholders' agreement.
Sometimes companies award special classes of shares to employee groups, mainly because they don’t wish to award them similar rights to other shareholders, like voting or dividends. In addition, employees may be required to give back or sell their shares if they leave, or if the majority shareholders want to sell. There may be employee options outstanding that give the right to employees to purchase or receive shares when they are exercised, and there may be special types of shares that exist like growth shares or employee shareholders shares.
Why is it important to collect this information?
The reasons for wanting to know about existing employee share schemes in the context of due diligence are:
- Employees will expect to sell their shares as part of the transaction, and there may be share options outstanding that will be affected by the sale.
- There may be tax implications associated with the schemes that could cause tax charges to arise (or reliefs to be lost) if the transaction goes ahead.
- You may want to adopt new share schemes post transaction or award employees shares in the buyer’s existing schemes.
Finding out the rights of employees/shareholders
If employees own shares in a company being sold, they will usually want to sell their shares to the buyer. The terms on which these shares are sold will be described in the Share Purchase Agreement (SPA). If there are existing share awards or options outstanding, you’ll need to find out if these have vested (in other words, that the employee can exercise the option to buy or receive shares), and whether the sale itself may cause these options or awards to vest, because, as a buyer, you’ll usually want to make sure you acquire 100% of all the outstanding shares in the target company.
Warranties in the Share Purchase Agreement
Although employees may own shares in the company for which they work, they don’t often have senior management responsibility so won’t be asked to make warranties in the SPA about the company being sold, although they may sign the SPA as a group of minority shareholders.
Finding out when when will vesting will occur
The rules around when awards of shares or share options will vest will be described in the share scheme agreement or plan. Vesting normally happens just before the sale has completed. From the buyer’s perspective, it’s better to have awards or options vest prior to completion to make sure that all outstanding shares are swept up by the sale, and so that the holders sign up to the SPA. Timing can be tricky, as all parties will need to be 100% sure that the sale will go ahead when the options and awards vest.
The best way to approach this issue is to communicate with the holders as soon as practicable (subject to commercial sensitivities) to tell them about the sale, to describe the vesting process, to explain how shares may be paid for (or if it’s possible to acquire shares without paying cash for them, known as a ‘cashless exercise’), any tax implications, and how the sales process will proceed.
Your lawyers will make sure that the sales process is tailored to take account of the employee share transactions, including using powers of attorney to sign the SPA on behalf of employees, and drafting the necessary documents. If, for any reason, the sale transaction doesn’t go ahead, the vesting can be set aside.
Are there any tax implications?
Capital Gains Tax (CGT)
CGT will be a relevant consideration for sales of shares acquired through employee share plans, where chargeable gains exceed the annual exemption for CGT.
Share Incentive Plans (SIPS)
If an employee holds shares under a SIP, provided the shares remain held in the SIP until just before completion, there should be no CGT as the SIP trust shelters the shares from CGT.
Save As You Earn (SAYE)
If employees have bought shares in a tax-advantaged manner under an SAYE scheme, they will be subject to CGT on the difference between the amount they paid to buy the shares (the exercise price) and the sale proceeds.
Company Share Option Schemes (CSOPs)
Employees will be subject to CGT on a sale of shares purchased through tax-advantaged CSOP options. This will generally be based on the difference between the sale proceeds and the exercise price.
Enterprise Management Schemes (EMI)
CGT will be payable on any gain (generally the difference between the market value of the shares at the date of grant and the sale proceeds) but business asset disposal relief may apply.
Non tax-advantaged schemes
CGT will generally be payable on a disposal of shares, where the shares have been held prior to the transaction (e.g. they aren’t acquired on the exercise of an option at the time of the transaction).
Income tax and National Insurance contributions at exercise
CSOP, SAYE
If a company changes control as part of a general offer for shares or a court sanctioned scheme of arrangement, income tax and for CSOP only, NICs, may become payable depending on the exact circumstances of the transaction. There are exemptions from income tax (and NIC) charges at exercise which can apply on corporate transactions.
EMIs
If an option to buy shares is based on the market value at the time of grant , there will normally be no income tax or NICs payable provided the option is exercised within 90 days of the sale. If the option is issued at a discount to market value at the date of grant, income tax and NICs will generally be payable on the difference between the option price and the market value at the date of grant.
Non tax-advantaged schemes
Income tax and NICs will be payable on the difference between the option price and the sale proceeds (market value at the time of exercise)).
How we can help
Purchasing a company can be a great way to expand your business, whether into other sectors, geographies or simply to make economies of scale. Even in the early stages however, good legal advice is essential.
If you need assistance with purchasing a company or with due diligence relating to the seller’s share plans or implementing a new employee share scheme post-transaction in the newly acquired company, our corporate and employee share schemes solicitors can help. Complete the short form below and a member of our team will be in contact with you.
