Employee Ownership Trusts - Use of Share Options
Companies owned by employee ownership trusts (“EOTs”) can face challenges in incentivising senior employees in terms of recruitment and retention because the natural “exit” of a trade sale is not open to EOTs to reward senior executives via share options. The lack of an exit can make the use of share options more difficult. The company has to consider different methods of creating a market for the shares in order to access the benefits of share options.
In the vast majority of EOT owned companies the creation of a market via an IPO of a minority shareholding is not practicable for a number of reasons. An IPO may only be practicable for companies with a large turnover and profits operating in a sector that is attractive to institutional investors in order to overcome the block on a sale of a majority shareholding which will be retained by the EOT.
A trade sale will not be an option. The main rationale for becoming employee owned may be to avoid the prospect of a trade sale. Following the transition to EO, the tax consequences of a sale by an EOT may make such a sale prohibitively expensive in terms of tax, with a small proportion of the sale proceeds being retained by the employees. You can read our article outlining the tax consequences of sale here.
In order to access the benefits of share options, the company will be required to establish an internal market by the creation of an employee benefit trust (“EBT”). The EBT can have the same company trustee as the EOT but the EBT is a separately constituted trust with its own tax and filing responsibilities. The EOT cannot be used to create a market because an EOT is constrained by the equality requirement contained in the tax legislation governing the operation of an EOT. The equality requirement requires any issue of shares from an EOT to be distributed to employees in an equal way; the discretionary nature of share options for senior employees would breach the equality requirement.
Powers of the EBT
The EBT will have the power to buy and sell shares with employees in the company and also have the power to satisfy the grant of options by the company or even grant options on its own account. The EBT is funded by capital contributions from the company and in some circumstances the company can obtain a corporation tax deduction for the contributions (generally when the employee receives a taxable benefit from the EBT or would be taxable but for the availability of a tax relief).
In most cases, share options will be granted using the Enterprise Management Incentive (“EMI”) scheme which is incredibly generous and tax efficient for both the company and the employees receiving the options. For more detailed information about the EMI scheme please see our fact sheet.
A couple of technical points to bear in mind:
- There is an exemption for companies owned by a company trustee under EOT arrangements from the restriction on EMI options not being used by subsidiary companies. The EOT owned company is still treated as “independent” for the purposes of the EMI legislation.
- EMI share options can be granted by existing shareholders and therefore, any shareholders who retain a minority shareholding could grant an option over their remaining shares. Specific tax advice should be sought by the shareholders. The use of existing shares will prevent dilution of the shareholding held by the EOT by the issue of new shares.
- The EOT trustees must ensure that the EOT will always retain a controlling shareholding in the company after the dilutive effects of the issue of new shares to satisfy the grant of share options. Ceasing to retain a controlling shareholding will create a tax charge on the EOT (or even the founders who sold their shares to the EOT).
Terms of the share option
The EOT and the company will have to consider a number of factors when adopting a share option plan and granting share options including:
- Valuation of shares at current market value (with or without a discount for a minority shareholding reflecting the 100% ownership by the EOT). Valuation to be agreed in advance with HMRC for EMI options.
- Satisfaction of any exercise criteria (time based or performance measures) prior to exercise of the option and when the option will lapse.
- Trigger events for exercise of the option given there is no “exit”. “Retirement” as a trigger may not be an incentive. HMRC will challenge any exercise and sale mechanism which it considers to be “tax avoidance”, such as replacing an existing cash bonus scheme with the share options.
- Cash availability to pay for shares on exercise to allow a “cashless” exercise (involving a purchase of shares by the EBT) to allow the option holder to pay the exercise price and any tax due on the sale of the shares.
- Compulsory sale provisions if the option holder leaves employment with a requirement to offer the shares for sale to the EBT at market value (if a good leaver) or at the exercise price (if a bad leaver) under provisions contained in the articles of association.
- Managing the warehousing of the shares by the EBT to allow for the transfer to other option holders on exercise of options. The EBT could be subject to capital gains tax on any increase in value of the shares between the purchase price and any exercise price payable by an option holder.
Other issues to consider
A large company or group of companies may not meet the qualifying conditions for the use of the EMI share option scheme. The qualifying conditions include a group wide gross asset limit of £30m and a limit of 250 full time equivalent employees.
An alternative to the EMI scheme would be the Company Share Option Plan (“CSOP”) which will be increased from 1 April 2023 to a maximum value based on the market value at the time of grant per option holder of £60,000 (increased from £30,000) but with a minimum period between grant and exercise of three years. A CSOP is less attractive and less flexible compared to an EMI scheme.
The EOT and the company may wish to enter into a shareholders’ agreement with the new shareholders to govern how the shares may be sold in the future. For example, can a proportion of the shares be sold before leaving employment? The shareholders’ agreement may also cover the payment of a dividend to the employee shareholders equivalent to the EOT bonus paid to the employees to reflect the “investment return” on the shares. For example, if an EOT bonus of £90,000 is paid and the EOT holds 90% of the shares, the minority shareholders may expect to receive a dividend of £10,000 split between their shares.
The use of share options by EOTs is developing and still fairly new. Share options bring their own set of issues to consider and requires careful engagement with the employees to explain why some employees are now being treated differently to others in terms of obtaining a shareholding in the company. To paraphrase George Orwell in Animal Farm “Some employees are more equal than others” and this message requires careful communication.