Share Scheme Success

DAVID REID explains the role of employee share schemes in estate and succession planning.

Until recently, employee share schemes have been of interest mainly to larger companies and their advisers. However, in the last few years numerous small and medium-sized companies in the United Kingdom have taken steps to introduce such schemes and it seems that more are preparing to do so. Conferences on this subject are attracting record numbers of delegates and the Inland Revenue estimates that, each month, about 75 additional companies are granting enterprise management incentive share options for the first time.

This change in attitude amongst small and medium-sized companies may reflect the following factors.

• Low unemployment and the need of such companies to attract staff in the face of competition from quoted companies.
• New tax rules which encourage small and medium-sized companies to have employee share schemes. For example, the Inland Revenue estimates that since the introduction of tax advantages for enterprise management incentive schemes in Finance Act 2000, more than 2,100 companies have launched one of these plans.
• Significantly, the latest taper relief rules offer employee shareholders the prospect of capital gains subject to tax as low as 10 per cent.
• Better informed employees with an understanding of the wealth-building opportunities that equity in a small or medium-sized company can provide.

The company's agenda

Practitioners need to be aware of the special concerns of most small and medium-sized companies when introducing employee share schemes. These differ considerably from those of most public companies.

For the adviser, the introduction of employee share schemes by a smaller company is usually a complex assignment. It is often more challenging and time consuming than putting a standard share scheme into a large quoted company.

This may seem strange, but remember that for most quoted companies their ordinary shares are a currency with no particular scarcity value. The issue of additional ordinary shares to employees is not a crucial step. The value of the shares is known and the public limited company's shares are already freely transferable and widely held. The fact that ex-employees may remain as shareholders involves no particular difficulties. For many public companies the employee share scheme is another perk of employment, like health cover or the company car.

The share scheme itself tends to be a standard form legal document - the detailed rules of the share schemes of most FTSE 100 companies are very similar. Often, employees of public companies sell their shares in the market as soon as they get them. In contrast, the professional adviser to the small or medium-sized company must adopt a thoughtful and multi-disciplinary approach. It will often be necessary to advise on a variety of matters including:

• share valuation;
• additional safeguards for controlling shareholders;
• rewriting articles of association;
• tax, company and security laws;
• additional tax rules affecting 'close' companies;
• communication to employees; and
• ways and means for employees to sell unquoted shares.

For small and medium-sized companies, the introduction of employee ownership will often be a major commercial decision. This is because of the following.

• Unquoted ordinary shares in a small or medium-sized company are a scarce and therefore precious commodity. You or I cannot simply ring up a stockbroker and buy the shares. Membership belongs to a favoured few, often at the absolute discretion of a controlling shareholder.
• For the employee, equity participation is no mere perk of employment. It has greater significance, representing membership, involvement and empowerment. It may represent a real opportunity for capital wealth accumulation.
• It is usually not acceptable for ex-employees to retain their shares, so mechanisms need to be put in place to retrieve shares from departing employees.
• Because the directors are generally the largest shareholders, they themselves must bear the cost of equity dilution. They will only do so if they judge that the overall value of their company will improve substantially as a result of employee ownership.
• Greater discipline in corporate governance will often be called for when employees have a personal interest in the value of their employer's shares. Non 'arm's length' transactions between the company and its founding shareholders will not be appropriate.
• It will no longer be appropriate to keep tax values of shares as low as possible. Employees will want to see rising share values. This represents a conflict with the usual wish of controlling shareholders to demonstrate low values (e.g. for estate planning purposes).

For all these reasons employee share ownership is not something lightly undertaken by small and medium-sized companies. In most cases, an urgent need to recruit, motivate and retain employees is the commercial imperative that drives these companies into what they would prefer to defer. For them, the share scheme is far more than a perk and carries with it important messages to employees.

Concerns of controlling shareholders

As a practitioner advising the small and medium-sized company or its controlling shareholders you will soon find that there will be no share scheme unless you can reassure your clients on a number of key planning points by answering the following questions.

• How can we keep voting control?
• How can employees afford to buy the shares?
• How do we get the shares back if the employee leaves?
• Will employee shareholders be entitled to see confidential information of the company, such as management accounts?
• Will we still be free to fix our own remuneration and benefits as controlling shareholders and as the principal risk takers?
• How can we ensure that the share scheme cannot impede a key corporate decision such as trade sale, merger or floatation?
• What will it cost us (i.e. the company) to establish and administer the scheme?

Estate and succession planning

We have found that the introduction of employee share schemes can add value in various ways which controlling shareholders and their advisers may not have expected. These additional features tend to subsidise the implementation costs of the share scheme itself and will often be very attractive to clients.

In contrast with quoted companies, small and medium-sized companies are less concerned with staying in line with peer group companies. Every small and medium-sized company will have a unique agenda, so there is often a willingness to consider special design choices which reflect the particular circumstances of the company.

Share reclassification strategies

In order to make the client company's shares more affordable for the employees (and also for various other reasons) we frequently recommend that the small and medium-sized client company should first implement a share capital reorganisation. This is designed to create new preference shares and new ordinary shares. It may involve, for example, the substitution of a 'cocktail' of nine preference shares and one new ordinary share in the place of every original ordinary share in issue as shown by Example 1 below.

This step often appeals to the controlling shareholders, whose voting, i.e. control, rights and prior claims to dividends and winding-up proceeds can be entrenched and 'ringfenced' within the new class of preference shares. In this way, up to the entire current value of the client company can be allocated to the new preference shares. This in turn may make it easier to allow employees to acquire new ordinary shares. Controlling shareholders will see that they will not be diluting their ownership of the present value of the company and not relinquishing voting control. Dilution will be confined to the new class of ordinary shares and so employees will have a stake in future growth, but not in the current value, of the small or medium-sized company. This provides 'downside' protection for the founder shareholders.

Share reclassification also radically adjusts the risk and reward balance so that the new ordinary shares become affordable and highly attractive to employees. The risk of investment loss is limited to the current low value of the new ordinary share. The 'upside', i.e. the prospect of large capital gains, becomes much greater and taper relief will apply so that any gains are very lightly taxed in the employees' hands. So there may be no need for the complexities of share options whether approved or unapproved, a simple so-called 'employee share acquisition plan' may suffice. Companies such as property, hotel, finance and subsidiary companies that cannot grant enterprise management incentive share options may find that the share reclassification offers an ideal solution.

Careful attention to the tax detail is essential including prior tax clearances.

Capital tax planning

Having reclassified our client company's share capital into preference and ordinary shares as shown in Example 1, some very interesting capital tax planning opportunities open up.

A new ordinary share which is worth for tax purposes 1p today but which may be worth 100p (£1.00) or even 1,000p (£10.00) in just a few years time is of interest to every capital tax planner. Modest underlying growth of the company's business can lead to spectacular growth in value of the new ordinary shares. This is illustrated in Example 2, below. These new 'B' ordinary shares are 'turbocharged' and may be used with tax advantages:

• to settle into a discretionary trust;
• to enrich childrens' or grandchildrens' trusts; or
• as part of an asset protection strategy.

An employee benefit trust

It is often the case that an employee benefit trust is set up by the employer company in order to facilitate the workings of employee share schemes. Usually the trust will be offshore in order to minimise tax and regulatory problems.

Great care is often needed in setting up the employee benefit trust, especially so as to avoid the implication that the employee benefit trust will make a market in company shares. Adverse National Insurance and pay as you earn problems may otherwise result.

The employee benefit trust can limit dilution by recycling existing shares and avoiding the need to issue additional shares to employees. Subject to careful tax planning, founder shareholders may be able to sell some of their shares to the trust and pay only 10 per cent effective capital gains tax on the sale proceeds. This enables founders to diversify their asset portfolio whilst maintaining voting control of the company.

School fees planning

A grandparent will be delighted to find that his original low yielding ordinary shares have been reclassified into high yielding preference shares and highly geared new ordinary shares. He or she can now afford (for example) to gift by way of declaration of trust some of the preference shares to grandchildren who can then use their own tax allowances and contribute to their own school or university fees.

Asset protection strategies

Advisers will often consider that the founder shareholder of a successful small or medium-sized company is the beneficial owner of too many shares. In this position he is a target for vexatious and other litigants. He may also be caught out if, at a future date, the current fairly benign United Kingdom tax rules concerned with, for example, inheritance, gifts, domicile and emigration are modified.

The share reclassification opens a new window of opportunity to improve matters at low tax cost. For example, a discretionary trust might use funds provided by a grandparent or more distant settlor to subscribe for some new ordinary shares at valuation.

Conclusions

The introduction of employee share ownership by a small or medium-sized company is a matter of great significance for the company and its controlling shareholders. To achieve a satisfactory outcome advisers must think beyond the narrow subject area of Inland Revenue approved schemes. A comprehensive solution can often be achieved through which both controlling shareholders and employees are enriched. Professional costs involved will be far outweighed by the advantages obtained.

David E Reid is a solicitor and chartered tax practitioner. He runs the London share schemes consultancy, Reid Associates, and can be contacted on 020 7243 2670 or by email david.reid@reidassociates.co.uk.

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