Retention is a key issue for businesses operating in the technology sector, both because of the high demand for skilled employees and also the more transient nature of the profile of employees in the sector.
Technology businesses need to make sure their key employees are incentivised in the right way to ensure they stay, and that the business is able to continue to scale at a fast-moving rate. The nature of high growth businesses is such that they have high cash burn rates, and typically lack the ability to reward employees through higher levels of salary and bonuses.
However, incentivisation by equity reward can act as a perfect retention tool for a number of reasons.
- It directly aligns the objectives of the main shareholders with the employees, to grow the value of the business.
- Unlike a bonus, equity rewards can be linked to, and reward continued employment.
- Firms in the technology sector typically have a future plan for exit or investment which can provide a clear point for employees to realise value from their equity awards.
On the face of it, the award of equity to an employee is a taxable benefit, subject to tax in the same way as a cash bonus, which can be problematic where employees receive shares without any cash to settle the arising tax liability. This can potentially negate the positive aspects of the award and even create friction between the employee and business.
There are, however, ways for high growth technology businesses to provide equity in a more tax efficient way.
Enterprise Management Incentive (EMI)
The most utilised tool by technology businesses is the Enterprise Management Incentive (EMI) option scheme. Employees are given options with rights to acquire shares in the future. The popularity of this scheme reflects its tax efficiency and the flexibility in how it can be structured.
The main attributes of EMI are as follows:
- At the point of options issued, there are no tax implications
- The business agrees the market value of the shares under option with HMRC, typically with a significant minority discount applied
- As long as this value is used as the exercise price in the future, no tax should arise on exercise, even if the shares have significantly increased in value at this point
- Any gain arising on a subsequent sale of the shares is then subject to capital gains tax, potentially at a rate of only 10% providing that the options/shares are held for a two-year period
- The company also receives a potentially valuable corporate tax deduction on exercise, equal to the difference between the market value and exercise price
In its simplest form, EMI can be utilised with an exercise immediately before an exit/investment event, so that the acquired shares can be disposed of straight away. This is known as a cashless exercise, in that no actual investment is required by the employee, the exercise price can just be taken out of the proceeds of the disposal by the company.
An EMI scheme can also be structured so that options vest or can be exercised at different times, sometimes based on length or service or meeting of performance criteria. The potential downside being the investment needed by the employee to exercise, and for existing shareholders a possible dilution of control and rights to dividends. However, every scenario is different and sometimes both parties want the employees to have a physical shareholding.
The 10% tax rate compares favourably to a bonus award, straightforward issue of shares or if the employee had held unapproved options, where the tax rate could be as high as 47% plus an employer’s NIC liability for the company.
The below illustrates the tax impact for an individual of a grant of EMI options in comparison with a grant of unapproved non-tax advantaged options. In this example, we have assumed the company value is £2m and that there are 100 shares in issue. Individual A is granted options (over existing shares) to acquire 5 shares which have a market value at the date of grant of £100,000. For the purposes of the comparison calculation, we have assumed the individual will exercise the options immediately before an exit event. At this point the value of the company has risen to £5m. The example is relatively simplistic, and we have ignored the corporation tax relief available but illustrates the tax benefits.
Illustrative numbers:
| Company value at time of option issue | £2,000,000 |
| Total number of shares | 100 |
| Value of options (5 shares) | £100,000 |
| Agreed value with HMRC including minority discount (70%) | £30,000 |
| Exercise price per share | £6,000 |
| Market value per share at time of exercise and sale (£5m/100) | £50,000 |
- On grant of options: no tax charge for either EMI options or Unapproved options
- On exercise of options, assuming that this is aligned with an exit event:
| Unapproved Options (£) | EMI Options (£) | |
| Market value on exercise | 250,000 | 250,000 |
| Less: exercise price | (30,000) | (30,000) |
| Gain | 220,000 | 220,000 |
| Income tax @ 45% | 99,000 | |
| Employees NIC @ 2% | 4,400 | |
| Employers NIC @ 13.8% | 30,360 | |
| Capital gains tax @ 10% | 22,000 | |
| Total tax payable | 133,760 | 22,000 |
Growth shares
Another tax efficient scheme and alternative to EMI is the use of growth shares.
Employees are issued with a new class of shares which have no rights to the inherent value of the business but provide access to a proportion of the growth in value from the date of issue. From a tax perspective the shares are deemed to have little or no value at the point of issue, such that only a minimal tax charge will arise on the employee at that point. The growth in value from that point would be subject to capital gains rates, expected to be 20%.
Psychologically, the employee may like the idea of holding real shares from the point of issue, albeit they are typically issued as a share class without voting or dividend rights.
A growth share scheme is typically more complex to implement, as they will require the forming of different share classes and potentially a change to the Articles of the company which EMI may not need. We therefore often see growth share schemes implemented in cases where companies may not qualify for the EMI regime. Having said that, it is possible to have growth shares under option within an EMI scheme.
Potential pitfalls and considerations
It is vital that any equity proposals are properly considered and advised upon to ensure that the appropriate and most beneficial reward is put in place.
At a basic level, any equity reward which is not understood by the employee or is considered unrealisable fails its primary purpose. Employees should be appropriately advised at the time to ensure that they are fully aware of the benefits and the focus on their performance and retention.
With EMI specifically, it is important that the scheme is implemented correctly. There are a number of conditions to be met and rules to be adhered to which can easily capture the ill advised. The most common mistake we see is a failure to register the scheme with HMRC within the correct timeframe, which automatically negates all of the intended tax benefits.
It is also imperative that businesses plan well in advance of any potential exit event. If they leave it too late then it will be impossible to leverage the tax efficiencies, as the equity values will already be high when the options/shares are issued.
Key takeaways for businesses in the technology sector
- Businesses need to plan to retain their key employees, and not leave it too late
- Seek appropriate advice and implement the best scheme for their circumstances
- Make sure the employees understand the scheme and are motivated by the potential benefits
- If possible, maximise the tax efficiencies which are promoted by HMRC through EMI