Employee Share Schemes Explained
What type of share plan can I use to incentivise our company staff, and how do they work?
Award share incentives to employees, while keeping their tax cost as low as possible
Employee share schemes are very popular with entrepreneurial companies who can offer shares or share options to help them employ and retain talented staff. The benefit of having a scheme is giving employees a chance to buy shares and benefit in their company’s growth alongside the owners - a powerful motivation when offered in addition to the usual salary package. Aside from the modest set up costs, there are few cash costs associated with share options, so they’re not a drain on company resources.
At the same time, you want to mitigate the cost and tax burden of giving employees any benefit. The lower the cost and tax, the better the incentive.
Why can't I just give shares to employees? - this is the big question! Well, you can, but they would have to pay up to 45% tax on the value of the shares, so it can get very expensive for them. There is also no guarantee that they can sell the shares in the foreseeable future, so they may just feel that they have pulled out a lot of money for no return anytime soon.
In the UK, there are four main schemes for employees. They can be used for key staff or the whole workforce. Three of the schemes award 'share options' rather than actual shares, while one scheme does issue shares:
EMI Scheme - grants share options to employees under a Government approved plan which is very flexible and saves lots of tax - some business types are excluded though such as subsidiaries, and certain activities including leasing, financial activities and property development.
CSOP - another Government approved plan using share options, which is open to all types of business trading activities.
For both schemes there is no payment upfront for the option award, and on selling the shares the employee pays capital gains tax at 10% or 20% rather than PAYE/NI at over 50%.
Growth share plans - 'growth shares' can be a substitute incentive where an EMI Scheme cannot be used. The company issues a special class of shares to employees, rather than award share options. The Growth Shares do not share in any of the value of the company that was created prior to their issue; the scheme preserves all the built-up value for the existing shareholders. then share in the future growth in value from the date of issue. There is a minimal upfront payment for the shares, and on selling the shares the employee pays capital gains tax at 20%.
Unapproved options - a share option plan normally used for non-UK based staff, non-execs, consultants and advisers.
Videos
You may be a start-up or several years into the growth journey but at some point every entrepreneur will want to sit back and work out how to incentivise employees beyond just a salary, free coffee, culture and warm words. Most will have heard of employee shares and share option schemes and have an idea that they can be a great inspiration. They are indeed, and better still put no demand on your cash flow.
In expanding companies, share schemes can help focus employees on the longer-term goals of the business. You may be aiming for a lucrative business sale in a few years; you're determined, committed and excited by the prospect. The big question is, do we share some of our equity in this business with some of the team? Will it enhance their commitment, and reward everyone with even greater value than if we stayed as we were?
How does a share option work? A share option agreement gives someone the legal right to buy a company’s shares in the future, but at a price that is fixed today. If the value of the company increases over time, the option holder could make a significant profit when they sell their shares, which make options very useful for companies that want to incentivise key employees.
Very simply, the company signs an agreement with an employee giving them a right to buy a set number of the company's shares at a set price at some point in the future. So let's say Julie is granted 20,000 shares under an option contract at a £1 ‘exercise’ price and four years later her company is sold to an even bigger software business at £10 per share. Julie buys for £20,000, sells for £200,000 and makes a cool £180,000 gain.
Psychologically, options make an employee feel more appreciated, because they are a benefit that can be awarded alongside the usual salary package. You’re saying, ‘we want you to stay with us and help grow the business, because we really value your input’.
Pragmatically, options can also help to recruit staff at salary levels lower than they might attract in other, bigger companies. If your company is exciting enough, a mix of salary, bonuses, share options, free pizza and diet coke or whatever can have the edge on joining some big, bureaucratic multinational.
Scheme design is generally very flexible. Options could vest over a period, perhaps so many shares per year over three years, or perhaps simply have all of the options vesting on the date of an exit event, so that shares are bought on the day of the company sale and then immediately sold alongside the existing shareholders.
Any gains made on selling shares will of course attract the taxman's interest, and an employee would normally pay income tax at up to 45% (plus NI) on their gain. However, there is a brilliant scheme which removes the tax nightmare and enables eligible employees to pay capital gains tax instead, and at a rate of only 10%. It's called the EMI scheme and it’s easily the best employee share scheme out there.
Introduced by the Government specifically to encourage employee share ownership, the scheme is supported by all sides in Parliament. EMI ‘wraps’ really good tax benefits around what would otherwise be a straightforward share option contract between the company and an individual. Under EMI no income tax is payable when the options are granted, or when the options are exercised to buy the shares. When an employee sells their shares, they will keep 90% of any profit. The company itself also gets a tax credit which is offset against its corporation tax.
Costs involved in setting up a scheme are low, as are ongoing expenses, so there is little cash outlay compared with the huge incentivisation payback.
For employees, the EMI option scheme is usually the most beneficial but if the company or an employee is not eligible for some reason then there are other forms of schemes and incentives that may be suitable. 'Growth shares' and 'CSOPs' are good alternatives. EMI is not available for non-exec directors or consultants, as they are not employees, or for non-UK employees, but they can be granted 'unapproved options' or given growth shares. We have useful guides to the various share and option schemes which can help you choose a suitable plan - click here to download or read on below.
Sometimes clients will use an EMI for their UK employees together with a growth share plan and/or unapproved options so that they can also incentivise non-UK employees, non-executives and consultants or contractors.