Six ways startups can incentivise staff

Whilst this seems like the simplest option to incentivise staff with equity, there are various issues associated with issuing shares to employees, contractors or directors. 

One of the main issues is that if an employee is allotted with shares or has shares transferred to them at less than their market value then the employee is likely to be subject to income tax on the value they are receiving. In addition, in some cases the company can be liable for Employers’ National Insurance Contributions as if the value of the shares being allotted were paid under the payroll. The same rules will apply to directors, and contractors might also be treated as receiving a taxable benefit. 

There are generally six potential solutions to this issue – buy-in, growth shares, nil-paid shares, phantom share schemes, restricted shares and options, as described below. 

Ask employees to ‘buy in’ and purchase their shares at full market value. There are several issues with this approach – firstly, HMRC might disagree as to what the value of the shares is, and secondly, often employees do not have sufficient funds to acquire shares at full value. 

Create a separate class of ‘growth’ shares which are designed to benefit from the ‘growth’ of a company above a certain threshold, typically the value of the business at the time of issue of the shares. 

These are shares (usually non-voting and non-dividend bearing) which do not participate in value on an exit up to the relevant certain threshold, only above it. A major advantage of this arrangement is that shares can be issued which do not have a value and may therefore be capable of issue at a lower price (although HMRC may challenge the hurdle value). 

To use a worked example, say there is a company with two founder shareholders. The founders decide to issue shares equal to 10% of the issued share capital of the company to employees allowing the employees to participate pro rata over £2m, which is the current estimated value of the business. Should the company eventually be sold for £5m then the two current shareholders would be entitled to the first £2m in proceeds. They would then be entitled to 45% each of the proceeds between £2m and £5m (£2,700,000), and the remaining 10% (£300k) would be payable to the employees. This allows existing owners to preserve the value they have built and also means that a very low valuation can usually be agreed for the options with HMRC. 

However, reserving value for existing shareholders, whilst fair, may not be as attractive for newer employees.

Another route is to issue shares to employees at market value but ‘nil paid’ or ‘partly paid’. This means that the shares are not paid for when issued (or the full value is not paid). This creates a debt owing from the employee to the company. 

There is usually an agreement as to when the shares will be paid up. Shares could be paid up from dividends or from the employee’s salary, or if paid up on an exit. 

The key downside for employees is that if the company becomes insolvent then the directors or liquidator will be obliged to ‘call in’ the amount owing from the shares, so essentially the amount unpaid is a debt obligation of the employee. 

A route which can be very flexible, if issuing shares or options to employees is not desirable or possible is to give the employees ‘phantom shares’. 
That is, a company gives the employee a cash bonus payable by the company equal to the value the employee would have received had they owned a certain number of shares in the company. The set-up costs of such a scheme are low but it is very tax inefficient as both the employee and the company will be subject to income tax and/ or national insurance contributions if a phantom or salary bonus scheme is used. There does also seem to be a psychological benefit for employees to holding equity or rights to obtain equity, which they wouldn’t with a phantom share scheme.

Restricted (or ‘reverse-vesting’) shares are shares in a company issued upfront to a member of staff subject to restrictions. Whilst the shares are actually issued to the relevant individual, they can be clawed-back by the company if that person leaves. As time passes, the restricted shares ‘vest’ and the restrictions are lifted.  

A UK based employee might be subject to income tax under the employment related securities rules, and even a non-employee (if they are a contractor) may be subject to income tax on the value of the shares issued to them. In many cases it may be possible to apply a lower value to restricted shares due to the fact that they are subject to various restrictions at the time of issue. 

The date on which the value of the shares is calculated for tax purposes is usually the date on which the shares are issued to the individual, and any increase in the value of the shares would be expected to attract a lower capital tax treatment. For that reason restricted or reverse-vesting shares are often issued by early-stage companies who can demonstrate a low initial value, and may be particularly useful if there are employees or contractors who do not qualify for a tax-advantaged option scheme.  

The other (usually preferred) solution is to give employees options over shares rather than directly issuing shares or giving them a bonus equivalent. Those options represent a contractual right to buy shares later at a price agreed today. 

This enables the employee to benefit from the growth in value of a company without needing to pay any money up front. It also means that no voting rights are diluted until such time as the options are exercised (if the options are over shares with voting rights).

We have considered the different types of options available in more detail in a separate article.

In summary, in most cases ‘buy-in’ by employees is not realistic and usually businesses will opt for some combination of giving employees options and creating and issuing growth shares.

Please contact Sally Johnston or Guy Wilmot for further details.