Employees are likely to make a greater contribution to a business when they feel motivated and incentivised. Paying them more is a quick fix but may not be enough for those high flyers that are pivotal to a business, and may be receiving tempting offers from competitors.

Cash bonuses are a simple form of motivation but can suffer from high tax rates for the recipient and an employer’s national insurance charge on the employer. Also, unless a mechanism for entitlement to bonuses is written into an employee’s contract, they are payable at the employer’s discretion and an employee can never be certain that they will receive one, or how much it will be.

Experience suggests that the best way of motivating and retaining star performers is to give them a stake in the business. This can be done in a number of ways, as outlined below.

Where the business operates as a limited liability partnership, it is possible that employees can become members of the partnership. The flexibility offered by the partnership structure facilitates bespoke structuring of an individual’s partnership rights to give them whatever profit share and say in running the business that is considered appropriate. Whenever new partners are admitted, or existing partners’ rights changed, tax as well as legal advice should be taken.

Employees will more commonly be employed by a company and the main way in which employees can be given a stake in a company is through some form of participation in its share capital.

If shares are given to an employee outright, either by the company issuing new shares to the employee or by existing shareholders transferring some of their shares, the employee will be liable to income tax on any difference between the market value of the shares at the time of receipt and the amount actually paid for them. Where the company already has significant value, this means that to avoid an income tax charge the employee needs to pay the market value of the shares, which may not be practical.

While giving up a minority stake in a company is unlikely to mean that the existing shareholders will lose control of it, they may be uncomfortable with employees holding the same class of shares as themselves. Generally, a company is free to create new share classes with whatever rights (e.g. voting, dividends, participation in the proceeds on a winding up or from the sale of the company) it chooses. This gives rise to a number of planning opportunities that can incentivise, lock in, and help the business grow so that everyone benefits.

For example, a company could create a new class of ‘growth shares’, which have the right to share in proceeds from a future sale of the company in excess of a ‘hurdle’ amount, usually set at or just over its estimated current value, and some of these growth shares are then issued to an employee. It is advisable to agree a value for the growth shares with HMRC, but they will typically have little or no value when issued so negligible tax charges arise at this time. On a future sale of the company, the employee will pay only capital gains tax on their proportion of the sale proceeds. If the growth shares have been held for at least 12 months and amount to 5% or more of the company’s total share capital, the employee will pay tax on the proceeds at 10% as they should qualify for the entrepreneurs’ relief capital gains tax rate.

To put this into context, suppose that a company has a current value of £1m. It creates a class of growth shares giving the holder a right to participate in sale proceeds from a future sale of the company in excess of £1m. The company issues some of these growth shares to an employee giving them a shareholding representing 10% of the total issued share capital of the company. Three years later the company is sold for £3m. The employee’s growth shares will realise 10% of £3m-£1m, i.e. £200,000 and the capital gains tax liability will be a maximum of £20,000, providing at least £180,000 after tax profit for them.

Share options are a popular alternative to giving an employee shares outright which would dilute the existing shareholdings. The most tax-efficient types of share options are those that qualify under the HMRC approved Company Share Option Plan (CSOP) or Enterprise Management Incentive (EMI) scheme. A key difference between the CSOP and EMI regime is that under CSOP the cap on the value of an individual employee’s unexercised share options is £30,000, whereas under EMI the cap is £250,000. For this reason EMI options are the overwhelmingly more popular choice. However, EMI options can only be granted by trading companies. Investment companies wishing to issue share options would have to issue either CSOP options with the £30,000 limit outlined above, or ‘unapproved’ share options, to which no cap or restrictions apply.

EMI options are highly flexible and have a more favourable tax treatment. They can be granted over most classes of shares, including growth shares, and can be exercisable either on a future ‘exit’, usually defined as a listing or sale of the company to a third party, or on a specified future date or dates. In either case, exercise of the options can be made conditional on performance targets for either the company as a whole or for the individual employee, or a combination of the two.

Any company anticipating future growth in value should be considering growth shares or EMI options (or a combination of the two) as a way of motivating and retaining key employees and giving them a tangible stake in the future growth of the business. Sometimes it may be more appropriate to offer a simple cash incentive, but where cash flow is an issue and key employee retention is crucial, share options can be a very successful and affordable tool that works for both employer and employee. The option agreement is usually drafted with clauses that ensure that employees will forfeit any options granted to them if they leave the business.

Taking appropriate professional advice is necessary before you enter into any commitment to employees to ensure that the chosen strategy is the right one for you, your business and your employees. HMRC disclosure and sometimes approval may be required to secure the tax benefits briefly outlined above. Don’t forget that any immediate dilution of share capital or future commitments you make will have a lasting impact, and you need to understand the position if things don’t work out as anticipated as well as the results of a positive outcome.

Supplied by Lynne Rowland, Partner at Kingston Smith LLP

Views expressed in this article are those of the writer. No responsibility for loss occasioned by any person acting or refraining from action as a result of the material in this article can be accepted by Kingston Smith LLP or any of its associated concerns.

The article is based on the law current at the time of writing and no responsibility is implied or accepted by Kingston Smith in the event of any future change in the law that impacts on the contents.