by Steve Livingston on August 18, 2011
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Incentivising key employees by giving them an equity interest in the company not only makes sense from a motivational and employee retention perspective but it also makes good financial sense when cash is tight and tax can bite nastily on cash bonuses.
Many UK growing companies will qualify for the Enterprise Management Incentive Scheme (commonly referred to as EMI) which is a tax favoured share option scheme which allows qualifying companies to allow selected employees to share in the success of the company, perhaps on an exit.
Growing companies that qualify for EMI may also qualify for EIS (a similarly confusing tax acronym which stands for Enterprise Investment Scheme!). EIS is a tax break available to business angel investors in the sorts of growth companies typically favoured by EMI share option schemes.
There is normally no problem in a company acquring funding under EIS whilst incentivising key management or employees using EMI, however, one crucial point to watch is that EIS is only available in respect of new ordinary shares which do not carry preferential rights. Care must therefore be taken to ensure that shares issued under an EMI scheme do not contain restrictions that might, by default, make the EIS shares preferential within the three year EIS qualifying period. If the the ordinary shares issued to the EIS business angel investors “become” preferred to the shares over which the EMI options are granted within the 3 year period then EIS status could be lost along with the tax breaks that go with it.
Ouch.
Although both EIS and EMI can form a happy marriage for most fast growing entreprenerial companies, they both contain strict conditions that must be adhered to if you are to avoid a potentially unsavoury divorce from your investors.
by Steve Livingston on July 21, 2011
Current tax rules require shareholders to be officers or employees of a company and hold 5% of the ordinary shares (and voting rights) for a 12 month period prior to sale to qualify for the holy grail of entrepreneur’s relief (ER) – ER results in a 10% personal capital gains tax rate (CGT) as opposed to a top rate of 28% CGT which is worth a potential £1.8m in tax savings.
I am currently encountering 3 common problems related to this condition in advising fast growth tech companies:
- Founders are seeing their equity being diluted as they approach much needed successive investment rounds and may therefore find themselves sinking below the 5% threshold - what adverse impact might this have on the funding decisions of business founders?
- You need to hold the 5% minimum requirement for 12 months prior to sale – what about employee shareholders who exercise share options just prior to sale (because that’s all the share option scheme permits)?
- What if a Founder is willing to share equity with a number of key employees (and reach the 5% threshold in each case) but is unwilling to relinquish voting rights? Especially if say 5 or more shareholders are given 5% each thereby breaching the 75% ownership limit necessary for passing special resolutions? Although this can often be managed via a shareholder agreement, some founders may be unwilling to enforce their (perceived) rights by suing for breach of contract.
Clearly, any tax incentive worth a potential £1.8m requires conditions and safeguards but it is disappointing when these conditions lead to skewed and sometimes uncommercial decisionmaking.
What changes or improvements would you like to see made to entrepreneurs relief?
