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How shares can help startups keep talent

Startups looking to attract and hang on to the best people could look at giving valued staff shares and options. Employee ownership specialist lawyer Robert Postlethwaite reports on a new survey of tech businesses in this area.

Robert PostlethwaiteCompetition for talent is fierce and international. As soon as you start thinking about taking on your first employee or contractor, you’ll need to think carefully about how to reward them. Cash may be in short supply initially or non-existent. And, while a successful fundraising may alleviate that problem, it probably will still not be enough to pay big company salaries.

That is one reason why, as the founder of a technology business, it might not be long before thoughts turn to partly rewarding your people through shares or options (equity). This enables more of the company’s scarce cash to be harnessed for other purposes and it creates a reward whose value is linked directly to the company’s fortunes, with potential for significant financial return if it achieves high levels of success.

It also introduces a longer-term reward element, placing participants more on the same journey as founders. An added benefit is that, compared with cash, equity rewards can be taxed at low rates for UK employees: at as little as 10% compared with between 46% and 60% for salary or bonus if both employee and employer taxes are included.

When and how do you go about creating an equity or share ownership plan for your key people? Recent analysis of a sample of technology companies has looked at how they are creating employee share plans.

As soon as possible is often best. A growing number of companies will have it on their shopping list in their first months of trading. A company competing for talent with more established businesses that have deeper pockets often finds that offering equity helps tip the scales in its favour. The sooner employees can acquire equity, the greater the scope for their shares to grow in value.

Over three quarters of technology companies surveyed, and which have an employee equity plan, chose to grant share options. Instead of employees acquiring shares immediately, they are granted a right – the option – to acquire shares in the future for a fixed price. That price typically will be based on the shares’ value when the option is granted, so the employee’s reward will link directly to how much they grow in value.

In a company whose founders are working towards a sale or flotation as a way of turning their investment into cash through an exit, the employee’s right to purchase the shares often – but not always – crystallises at the same time as the exit.

Option holders will then exercise their options, and sell their shares making a financial gain. If they leave before the exit, they may lose their options, or what happens may depend on why they leave.

For UK staff who are employees (rather than self-employed), if their company is able to grant them enterprise management incentive (EMI) options, they will pay tax on their reward only when they eventually sell their shares, paying capital gains tax (CGT).

CGT is normally payable at 18% or 28%, but EMI option holders often are able to claim entrepreneurs’ relief, reducing the rate to 10%. This, combined with its flexibility and ease of setting up, has made EMI a popular choice.

In our analysis, over 60% of UK technology and other growth companies operating a share ownership plan for their employees have an EMI option plan. Of those that do not, in the main this is because they do not qualify for EMI.

EMI is available only to smaller companies (total assets of less than £30 million and fewer than 250 full-time employees) and is not permitted for companies whose trade does not qualify. Most technology companies should not find themselves on the non-qualifying list, although it is always important to check. If the company’s revenues include royalties, special care should be taken. EMI is not available for a company that is a subsidiary.

There are several alternatives to EMI, including other kinds of share option and also arrangements that involve immediate share acquisition.

Companies committed to significant and widespread employee share ownership may wish to take advantage of the creation this year of two new tax reliefs associated with businesses that become majority-owned by an employees’ trust. The reliefs provide the ability to pay income tax free bonuses to employees and for those who sell their shares to the trust to be entirely exempt from CGT.

Some businesses may have had assistance from advisers or consultants who are not employees but instead work as self-employed. They cannot be granted EMI options, but can still be granted options or shares. Under current UK tax rules, they will generally pay income tax on the value of the option or shares when granted, then CGT on any growth.

Robert Postlethwaite is managing director of employee ownership lawyer Postlethwaite. Contact him on 020 7470 8805, email rmp@postlethwaiteco.comView the findings of the Postlethwaite research in more detail