How to use shares to incentivise employees at a UK startup
By Tom Odlin, Date published: 2022-05-06
Allocating shares to a startup team
A key reason for joining a startup that early-stage founders and first hires often cite is the excitement of being a part of the next rocket ship.
Working for a startup typically means personal sacrifice and losing the security of a higher-paying role with established companies.
The dilemma of the founder or early founding team is how to incentivize additional core founders and build a highly skilled team by sharing this potential growth.
For a new company with only one shareholder, the simplest way to reward successful new hires is to give them shares. It is a straightforward process and involves minimal paperwork to issue shares to the employee and update the company register to add your new shareholders.
Zegal can help you issue shares to your team. Get in touch with us.
The benefits of your team becoming shareholders in the company are often psychologically important. Shares unite the team as ‘founders’, which helps foster an owner mentality, creating goodwill that fuels the startup vision.
Awarding unrestricted shares tends to be preserved for the earliest members of the founding team, who are then locked in to see the journey through. They are ‘on the bus’.
The drawback of this approach is that, while the team is anchored by share ownership, any team members leave do so with their shares. Nothing ties share ownership to their employment with the company, and this level of risk is naturally not appropriate for every worker.
Protect your shares using forward vesting
To countenance the risk of staff leaving with shares, it is common for early-stage companies to vest shares.
Vest means to award a specific number of shares to an employee, but over a specified period.
Example: Rather than awarding 1% of the company’s shares today all in one go, Sarah is asked to work for the company for one year, following which half her shares will be awarded. The other 50% are given over the next two years.
Share vesting has the obvious benefit that if Sarah leaves within a year for any reason (from performance issues to simply not wanting to work at the startup anymore), she does so without any shares. If she leaves after 12 months, she does so with half her shares.
Awarding shares like this are often referred to as restricted shares. Sarah does not own the 1% outright, and she will need to work for the company for at least three years to own them all.
Companies typically set out the restrictions in a share vesting agreement which may be quite detailed but typically govern how the employee earns the restricted shares, for example, by hitting certain work-related milestones, time with the company, and seniority. There are also restrictions on what happens to the employee’s shares if they leave the company earlier than planned.
The company ordinarily will not want to risk employees leaving early with shares or, worse, taking them after a bad performance. So it is common to see a “good and bad leaver” provision in share vesting agreements. These provisions handle situations in which employees are let go for poor performance or resign early, with differing economic outcomes for the employee. To learn more about share vesting agreements, please read this article.
When an employee receives shares, the shares will ordinarily be treated as income and taxed in the UK.
Contact Zegal if you need individual or company advice on restricted shares.
In addition, there is usually a tax event when the shares are actually sold, and the tax paid at that time is capital gains tax (CGT). These taxable events can surprise early-stage entrepreneurs who find that a significant portion of their expected windfall is taxed. This is especially so in startup companies that grow incredibly quickly, and the share value increases exponentially.
Reverse vesting of shares for tax purposes
After vesting, there is usually a tax event when the shares are actually sold, and the tax paid at that time is capital gains tax (CGT). These taxable events can surprise early-stage entrepreneurs who find that a significant portion of their expected windfall is taxed. This is especially so in startup companies that grow incredibly quickly, and the share value increases exponentially.
To address this situation, startups can use reverse-share vesting. Although complex sounding, this can be quite simply understood using the same example as above.
Example: Sarah is awarded 1% of the shares in the company, and again she will receive half after 12 months, with the remainder over the next two years. However, with reverse vesting, Sarah receives the full amount of 1% of her shares on day one. The company then has a right to take back her shares (often described as a clawback) which begins with a right to take all the shares back; reduced to a right to take back only 50% of the shares after 12 months, and then to zero after the full vesting period.
In this way, the same mathematical position is achieved, insofar as Sarah receives 1% of shares in the company over three years, only this time, she receives them all at the start.
Why use reverse vesting?
The idea behind this structure is that the startup’s shares should be at their lowest value in its earliest years. Hence, if an employee receives shares in a drip-feed over a more extensive timeframe, the potential for income tax increases dramatically as the value of the shares awarded does each year.
By making the legal transfer on day one at the company, the employee benefits from the award with a low value and could benefit from the lower tax.
Navigating the tax implications of vesting shares
To benefit from reverse vesting, you will need to arrange for your startup and the employees to enter into what’s known as a section 431 election, which is filed with HMRC.
The effect of this election is that no tax is paid by the employee on the date the shares are awarded. It can reduce the tax payable to only capital gains tax (CGT) (at the Entrepreneur Relief level of 10%, payable on the gain in value when the shares are sold). This election must occur within 14 days of the share vesting agreement being signed.
Zegal can assist you and offer individual and company advice on a section 431 election. Contact us here.
It is worth noting that from a tax perspective, for pre-seed or pre-revenue startups (if not fundraising), giving shares to the team at a nominal value does not create any of the above tax implications since the shares have no value at that time.