{"id":155020,"date":"2024-03-05T16:39:15","date_gmt":"2024-03-05T08:39:15","guid":{"rendered":"https:\/\/zegal.com\/?p=155020"},"modified":"2024-05-03T14:48:36","modified_gmt":"2024-05-03T06:48:36","slug":"how-to-use-shares-to-incentivise-staff-at-a-uk-startup","status":"publish","type":"post","link":"https:\/\/zegal.com\/en-gb\/blog\/post\/how-to-use-shares-to-incentivise-staff-at-a-uk-startup\/","title":{"rendered":"How to Use Shares to Incentivise Employees at a UK Startup"},"content":{"rendered":"\n

<\/span>Allocating shares to a startup team<\/span><\/h2>\n\n\n\n

Early-stage founders and first hires often cite excitement as the key reason for joining a startup<\/a>. <\/p>\n\n\n\n

Working for a startup typically means personal sacrifice and losing the security of a higher-paying role with established companies.<\/p>\n\n\n\n

The dilemma of the founder or early founding team<\/a> is how to incentivise additional core founders and build a highly skilled team by sharing this potential growth.<\/p>\n\n\n\n

<\/span>With shares, you must start at the beginning<\/span><\/h2>\n\n\n\n

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 update the company register and shareholders agreement<\/a>.<\/p>\n\n\n\n

The benefits of your team becoming shareholders in the company are often psychologically important. Shares unite the team as \u2018founders\u2019, which helps foster an owner mentality, creating goodwill that fuels the startup vision.<\/p>\n\n\n\n

The drawback of this approach is that, while the team is anchored by share ownership, any team members leave to do so with their shares. <\/p>\n\n\n\n

Nothing ties share ownership to their employment contract<\/a> with the company, and this risk level is naturally inappropriate for every worker.<\/p>\n\n\n\n

<\/span>Protect your shares using forward vesting<\/span><\/h2>\n\n\n\n

To countenance the risk of staff leaving with shares, it is common for early-stage companies to vest shares.<\/p>\n\n\n\n

Vest means awarding a specific number of shares to an employee over a specified period.<\/p>\n\n\n\n

<\/span>Example of forward vesting<\/span><\/h3>\n\n\n\n

Rather than awarding 1% of the company\u2019s 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.<\/em><\/p>\n\n\n\n

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. <\/em><\/p>\n\n\n\n

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.<\/p>\n\n\n\n

Companies typically set out the restrictions in a share vesting agreement, <\/a>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\u2019s shares if they leave the company earlier than planned.<\/p>\n\n\n\n

The company ordinarily will want to avoid employees leaving early with shares or, worse, taking them after a bad performance. So, a \u201cgood and bad leaver\u201d provision in share vesting agreements is common. These provisions handle situations in which employees are let go for poor performance<\/a> or resign early, with differing economic outcomes for the employee.<\/p>\n\n\n\n

When an employee receives shares, the shares will ordinarily be treated as income and taxed in the UK.<\/p>\n\n\n\n

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 increase share value exponentially.<\/p>\n\n\n\n

<\/span>Reverse vesting of shares for tax purposes<\/span><\/h2>\n\n\n\n

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.<\/p>\n\n\n\n

To address this situation, startups can use reverse-share vesting<\/a>. Although complex sounding, this can be quite simply understood using the same example as above. <\/p>\n\n\n\n

<\/span>Example of reverse vesting of shares for tax purposes<\/span><\/h3>\n\n\n\n

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 gets the complete 1% of her shares on day one.<\/em><\/p>\n\n\n\n

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. <\/em><\/p>\n\n\n\n

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. <\/p>\n\n\n\n

<\/span>Why use reverse vesting?<\/span><\/h3>\n\n\n\n

The idea behind this structure is that the startup\u2019s 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.<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

<\/span>Navigating the tax implications of vesting shares<\/span><\/h2>\n\n\n\n

To benefit from reverse vesting, you will need to arrange for your startup and the employees to enter into what\u2019s known as a section 431 election, which is filed with HMRC.<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

<\/span>What is the difference between shares and share options? <\/span><\/h2>\n\n\n\n

When you give your employees shares, they immediately become shareholders. They now wear two hats: As an employee and a shareholder with all the rights that come with being a company shareholder, for example, rights to a dividend, voting rights, and the growth in financial value.<\/p>\n\n\n\n

A share option (generally referred to as an option) is different and is the right to buy shares in the future. Giving your employees options means they could be shareholders at some future time, but for that to happen, they would need to convert their options into shares.<\/p>\n\n\n\n

Converting options into shares is known as \u2018exercising\u2019 the option. This mechanism allows an employee to acquire shares at some point in the future by \u2018exercising\u2019 the option at a price set at the award date. <\/p>\n\n\n\n

The ability to exercise the option is set out in their option agreement. It is likely contingent on the employee hitting certain employment milestones or the company achieving a landmark event such as significant fundraising, a trade sale, or an IPO. <\/p>\n\n\n\n

Share schemes can be split into those that have received HMRC approval and benefit from favourable tax treatment and unapproved schemes (which, as the name suggests, HMRC has not been notified of). The tax position (which primarily impacts the employee) when they exercise their options varies depending on which scheme is adopted. We will focus on the difference between the tax-advantaged EMI Scheme and unapproved schemes.<\/p>\n\n\n\n

<\/span>Enterprise Management Incentives (EMI Scheme): <\/span><\/h2>\n\n\n\n

EMIs are tax-advantaged share options. Under the\u00a0share option plan<\/a>, employees are allowed to acquire company shares within a specified period and at a fixed price, set up to minimise employee tax. There are strict criteria for setting up an EMI Scheme, but most early-stage startups can satisfy these:<\/p>\n\n\n\n

<\/span>Qualifying companies <\/span><\/h3>\n\n\n\n

EMI is available to companies with gross assets of \u00a330m or less. In a group, the gross assets test is applied to the group.<\/p>\n\n\n\n

The company must carry on a qualifying trade; most tech companies<\/a> usually qualify. Trades that do not qualify include leasing, farming, financial activities, and property development.<\/p>\n\n\n\n

If you have a group setup (with a Holdco), EMI share options must be granted over shares in the parent company (the Holdco), and at least one of your subsidiaries must carry on the qualifying trade.<\/p>\n\n\n\n

Your startup must not be under the control of another company. (However, the parent company of a qualifying group can grant EMI options to group employees.)<\/p>\n\n\n\n

<\/span>Qualifying options<\/span><\/h3>\n\n\n\n

Options must be granted to employees or directors over fully paid shares that are not redeemable. The shares can be subject to restrictions.<\/p>\n\n\n\n