The ultimate guide to growth shares

If you want to attract talent and enable employees to invest in your limited company without handing over voting power to lots of other people, offering growth shares could offer an attractive solution.

Every company owner wants to be able to hire the boldest and brightest individuals to join their respective teams. Unfortunately, attracting top talent can be incredibly tricky — particularly if you’re operating a new start-up or a small business with few resources to offer flashy hiring incentives to new starts.

But one dynamic solution that an increasingly large number of small companies have started to deploy to enhance their hiring proposition is to offer growth shares.

Growth shares have proven to be an attractive incentive for both employees as well as non-employees, because they are very flexible and enable employees to become shareholders immediately without having to meet a number of statutory requirements or limits that are normally applied when new shareholders are added to a business.

But as always, there’s a little more to it than that — and there are also several rules and conditions you’ve got to be aware of before deciding to issue growth shares as part of your own corporate strategy.

This guide explains what growth shares are, why UK company owners choose to set up growth shares, how growth shares are taxed and how to issue growth shares.

What are growth shares?

Growth shares are a special share class that company owners can issue to both employees and non-employees as a way to allow these individuals share in the growth of a company’s value above a nominal valuation hurdle.

Growth shares are normally granted by private and unlisted UK companies. That being said, subsidiaries of AIM-listed companies on the London Stock Exchange also often grant them too.

In terms of how they differ from ordinary company shares, growth shares offer the holder partial ownership of a UK limited company. But unlike ordinary share classes, growth shares don’t typically offer the holder rights to dividends or voting rights. In fact, growth shares are typically restricted to participation on an exit-only basis.

For example, a growth shareowner could probably vote on a huge decision such as the sale of a company or an initial public offering — but a growth shareowner wouldn’t get to vote on routine decisions as part of an annual general meeting (AGM) of shareholders.

That makes growth shares attractive to employers because it means your say as an ordinary shareholder won’t be diluted by shareholding employees in respect of any existing “built-in value” of your company at the point in which any growth shares get issued. Likewise, it can be an attractive option for employees that want a financial stake in the company’s success without the extra responsibility.

Generally speaking, growth shares are designed around a conditional “hurdle” that will encourage the future growth of the company. For example, you might form a condition that your company’s growth shareholders will only share in any exit event proceeds that exceed a certain amount — like £20 million.

There is admittedly a possibility that your company won’t ever achieve the growth required to exceed that hurdle. As a result, growth shares tend to have a fairly low market value compared to ordinary shares. But that also makes growth shares a more affordable option for employees wanting to invest in your company.

Growth shares are often used as an alternative to Enterprise Management Incentives (EMIs).

EMI plans work similarly to growth share plans in that they allow employees to invest in the companies they work for — and ultimately share in any subsequent profit from exit events. But unlike EMI options, growth shares don’t have to be approved by HMRC.

When you set up an EMI plan, there are various conditions that need to be met by the employee, the employer, and the options themselves. EMI options also need to be exercised within 10 years of being granted. Simply put: if you don’t use an EMI option, you’ll lose your option.

On the flip side, growth shares don’t have a time limit. This makes them the preferable option for companies that aren’t expecting to hit an exit event in the medium term.

Why do company owners choose growth shares?

Just like any other share class a UK limited company might issue, growth shares go hand-in-hand with their own set of advantages and disadvantages.

In terms of the primary advantages a company owner can expect to gain by issuing growth shares, the first benefit is that growth shares issued upfront to employees have low acquisition costs. That makes it affordable for employees to invest, and affordable for employers to issue.

Next, issuing growth shares doesn’t lead to dilution for existing shareholders where current company valuation and position are concerned. From an employer’s point of view, this should offer some much-needed reassurance for current shareholders that their existing stake in a company won’t be lessened just because employees have started to invest in growth shares.

Finally, growth shares don’t have an expiration date. As we’ve already covered, EMI options expire after 10 years. That means if your business issues EMI options and you don’t reach the conditional hurdle associated with your exit event, your employees are going to miss out. That means the employee benefit you’ve been providing in the form of an EMI option is pretty much worthless.

By contrast, a growth share has no expiration date. That means if your conditional hurdle is that growth shareholders receive a portion of the profit associated with a company sale in excess of £10 million, it’s okay if it takes 15 years to get there. Growth shares are honoured in the long-term, which makes them preferable to smaller companies or brand-new start-ups.

That being said, it’s important to note there are a few disadvantages associated with growth shares that might put some company owners off.

First and foremost, employees must pay for the growth shares at the time in which they’re issued. That means this is an upfront investment expense for employees, which may be a cost barrier for a lot of your workers.

Another point to bear in mind is that if your employees are offered growth shares at a discount to market value, they’ll be expected to pay income tax. They may also need to pay National Insurance contributions (NICs) on the amount they were discounted — but we’ll go into detail on growth shares and how they’re taxed in just a minute.

You should also remember that HMRC doesn’t agree to a valuation for growth shares. That means in order to make sure your company is in a strong enough financial position to issue shares, you’re responsible for carrying out your own robust valuation each time you want to issue new growth shares.

Although this is simply good practice, it does add to the costs of operating a growth share plan. It also creates an extra degree of uncertainty, because there’s no guarantee that HMRC will accept any share valuation the company has reached at a later date if you do opt to go for the EMI option plan later.

Finally, if you want to create a new class of growth shares, you’ve got to alter your company’s articles of association (which are one of its founding documents). But depending on the size of your company and how you make updates, that may not be much of a hurdle.

How are growth shares taxed?

If growth shares sound like an intriguing proposition to you as a company owner, it’s crucial that you understand how growth shares are taxed.

To your employees, growth shares represent a tax-efficient way to invest in your company. That’s because growth shares effectively have no monetary value attached to them when they’re issued. This means you can issue growth shares to employees at a relatively low nominal price that is free of any tax liability.

That being said, your employees will only be able to purchase growth shares tax-free if they’ve been purchased at a fair market value. If you gift employee growth shares or let them buy shares at a discounted price, they’ll need to pay income tax on the difference between what they paid for the shares and the fair market value of those shares.

For example, let’s say the fair market value of a growth share in your company is £1,000. But you let your employees purchase one share each for just £100.

That means your employee will need to pay income tax on the remaining £900 via HMRC Self Assessment. They may also end up having to pay an NIC depending on how big of a discount they received.

When your company is sold (which is an example of those “exit events” we keep talking about), every employee holding growth shares will receive a financial payment as long as the sale has met the conditions of any associated hurdle.

But upon receipt of this financial gain, each growth shareholder will need to pay capital gains tax on the proceeds of the sale and benefit from their annual capital gains tax allowance. This will normally be at a rate of either 10% or 20%, depending upon the amount gained.

How do you issue growth shares?

For those company owners keen on issuing growth shares as an employee benefit, it’s relatively simple to establish a growth share plan.

First, you’ve got to draft amendments to your limited company’s articles of association in order to establish the creation of a new class of shares (growth shares). You may need to add additional provisions to make sure there are sufficient protections to ensure dilution and exit events are handled appropriately.

Next, you’ll need to obtain a shareholder agreement to amend the company’s articles of association. If you are the company’s sole shareholder and director, the job of approval is pretty simple. But if your company already has quite a few existing ordinary shareholders with voting powers, you may need to arrange a meeting with your fellow shareholders to carry out and record a vote.

You’ll then need to obtain a valuation for your growth shares.

Unlike EMI plans, you’d have to get in touch with HMRC and arrange for the body to pre-approve the value of your new shares. With growth shares, HMRC doesn’t get involved in any valuations you might need to be done. Instead, you’ll need to have your accountant carry out a valuation — which is typically a small premium above the company’s existing value.

Depending on the type of company you’re running, that premium could be anywhere between 10% and 40%. Just make sure your accountant or valuation specialist is being realistic. If HMRC takes a look in the future and decides that the shares had been undervalued at the point of issuing, employees would likely be expected to pay retrospective income tax on the difference.

After that, you’re able to enter into a growth share subscription agreement with the relevant employees and then issue them their new growth shares.

The bottom line

At the end of the day, growth share arrangements are pretty straightforward to initiate. More importantly, they offer an attractive alternative to non-tax-disadvantaged share options and more rigid options like EMI plans.

Bearing that in mind, growth shares can be a dynamic way to incentivise your hiring campaigns and attract talented individuals who are keen on taking on a stake in your company.

Just remember to do your homework and consult an accounting professional prior to taking the plunge. There are tax implications both you and your employee investors must be aware of. Likewise, you’ve got to ensure that you follow all the correct procedures in altering your company’s articles of association and developing a share program that will withstand the test of time.

But if you take your time and tread carefully, growth shares can be beneficial for both employees and their employers in the long term.

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