Realising value: the importance of correctly structuring equity ownership

The after tax outcome may differ by as much as 40-50 per cent of the proceeds realised dependent upon the applicable tax rules: essentially whether the gain realised on the sale of the shares is treated as capital or as income for tax purposes.

It is clear enough why this might matter to the individual vendor shareholder who wishes to minimise the tax they pay on their gain but why should the purchaser be concerned? The default answer, and a recurring one in this series of articles, lies in the importance of recognising the key drivers for the purchaser.

The purchaser will be looking to acquire a business with an experienced, motivated and incentivised management team, not simply at founder and senior management level but throughout the organisation and extending to that all-important “second tier”. The purchaser might expect to see as much as 30 per cent of the overall equity allocated to key hires and the second tier sitting alongside the equity interests of the founders and senior management.

The purchaser will want to satisfy themselves that the existing equity ownership arrangements reflect that expectation: that management and key personnel at all levels have a stake in the business and that these equity incentives are tax efficient both for the individuals and the company. Underlying this (and the subject of a future article in this series) the purchaser will wish to structure the “earn out” to achieve their commercial objectives and, again, tax efficiency. The earn out represents further consideration for the shares linked to the future performance of the company and effectively makes the purchaser collectively responsible for the tax efficiency of the vendors sale!

So what of the different tax treatments? Capital gains are generally taxed more favourably than income and some capital gains more favourably than others. Gains arising on the sale of shares in a trading company will generally benefit from a special rate of capital gains tax of 10% being the entrepreneur’s relief rate. This will apply to the founder shareholders and those senior members of the team who have an existing 5 per cent shareholding, and sets the “bench mark” expectation for the remaining shareholders.

If the Company wishes to incentivise the second tier with equity participation, this should be implemented by way of share options. This is simply the best commercial solution and has no regard to tax. Options may vest in accordance with an almost infinite variety of performance metrics tailored and designed to the circumstances of each individual grant. Importantly, their vesting may be made conditional on a sale or exit and forfeited on cessation of the employment. Options represent an effective ongoing incentive (compared to the “sunk” benefit of an issued share) and are “self-regulating” in as much as the benefit may only arise on a sale. This is otherwise irrelevant and automatically recovered on cessation of employment (again compared to the difficulty in recovering an existing shareholding).

The critical thing, however, is to ensure that any option is implemented under the tax approved rules of the Enterprise Management Incentive Scheme (EMI). If an option exercised on a sale is “unapproved”, it is effectively taxed as a terminal bonus with the proceeds of the share sale subject to income tax at marginal rates, inclusive of employees’ NIC, of 47 per cent – and greater still if the option terms require the employee to bear the employer’s NIC cost of 13.8 per cent.

The EMI provides a relatively light touch tax favoured (tax approved) option that switches off the employment income charge on the value of the shares delivered under the scheme. This simply charges to capital gains tax, and at the entrepreneur’s relief rate of 10 per cent, the gain realised on the eventual sale of the EMI shares. The EMI scheme puts the option holders (the second tier) in the same place for tax purposes as the founders: that is a gain realised on sale taxed at the headline rate of 10 per cent.

The EMI therefore achieves equality of tax treatment for all the shareholders on an exit and is key to correctly structuring equity ownership. But the advantage goes beyond the implementation of an equity incentive valued by the second tier and the prospective purchaser: the tax efficiency of the EMI allows the founder shareholder to deliver the same after tax gain with less dilution to the founders’ own equity interest—a win win.

By Natasha Frangos and Neil Simpson, Partners at haysmacintyre