by Jaspal Pachu (Partner), and Cathy Wears (Of Counsel) at CMS
Founders could be forgiven for neglecting their share capital when a company is run from a spare bedroom and when turning a profit, let alone the idea of a company sale, is still a pipe dream.
The specifics of ownership are often forgotten in a flurry of administrative activities on company formation. An original founder may have taken a back-seat in the operation of the company, or an employee who was instrumental in launching the company may not have received equity at formation.
Fast forward a few years into the territory of investment rounds and potential exits, and who owns what becomes very important indeed.
Tax considerations
Founders (and key employees) are typically company directors (executives or NEDs) and are generally treated as employees of the company for tax purposes (even if they are not in fact employees).
Any shares they hold or acquire are therefore deemed to be ‘employment related securities’ (ERS) for tax purposes and their acquisition or disposal may be subject to income tax and potentially employer and employee NICs. For example, income tax may (amongst other circumstances) become payable (possibly under PAYE) if:
- shares are transferred to (or between) founders or other employees for less than market value;
- there is a disposal (or lifting of restrictions) where shares are restricted (for example have good or bad leaver provisions) and founders/employees fail to make the appropriate election and/or pay ‘unrestricted’ market value at acquisition; or
- shares held by founders or employees indirectly receive value. For example, where a founder shareholder is no longer involved in the running of the business and agrees to forfeit their shares in order to increase the value of the remaining founders’ and employees’ shares.
This rule also applies to both future and past employment and even where shares are made available to a person by virtue of another person’s employment. There is a potential dispensation for certain share transfers between family members where these are not considered to be employment related.
As time goes on and the company increases in value, the magnitude of the potential tax problem increases; it is therefore crucial to get the shareholdings correct as early as possible, when the value is low.
Valuation is key. The tax implications of moving around shares of little value are relatively minor, all that is generally required is a few filings at Companies House.
The difficulty is demonstrating and evidencing the value of the shares at the time of the transfer. It can be hard to argue to a potential buyer of a multi-million-pound business that the shares were once worth pennies and so there is no historic tax to consider.
Efficient alternatives
A founder share rebalance may be a good opportunity to increase the company’s option pool for employees.
Transferring excess founder shares into a ‘warehouse’ such as an employee benefit trust would not further dilute investors, and the company can then use these shares to incentivise employees through options or other equity awards.
Structured correctly, equity-based awards may be more tax favourable than cash bonuses to employees in the UK or overseas.
EMI options
For UK employees, provided the company qualifies, ‘enterprise management incentives’ options may be a good vehicle to help not only to get your founder shareholdings correct, but also incentivise the workforce or other founders.
EMI options provide certainty from a valuation perspective as HMRC will agree the tax value of the underlying shares in these circumstances (which they would not otherwise). An added bonus is that EMI options can even reduce employees’ tax liability on eventual disposal of the option shares from 20% to 10%.
