Last week's employee share scheme (ESS) webinar was packed with practical takeaways for companies looking to introduce, or improve, their employee share schemes. The event was split into two tracks: “An introduction to EMI schemes” with Jerry Davison, Managing Director and Founder of accountancy firm The Mill Consultancy, and “Alternatives to EMI” with Ian Shaw, Partner at Orrick, Herrington & Sutcliffe LLP.
This article summarises track one. Many thanks to Jerry Davison for taking part, and Capdesk Co-Founder Christian Gabriel for hosting.
An introduction to EMI schemes
Jerry opened the webinar by explaining that a share scheme is a process that gives individuals the opportunity to buy shares at a set price, at some point in the future.
“In a simple setup, you might give an employee options priced at £1 per share and the right to purchase those shares in three years’ time. When three years are up, the employee can buy those shares at £1, even if they’re now worth £50 each.”
EMI also affects the type and amount of tax employees can expect to pay when they exercise their options.
“The EMI scheme offers massive tax relief for employees. Instead of paying income tax on the difference [between the option price and the share price], they pay Capital Gains Tax. While income tax can be as high as 45%, Capital Gains Tax is currently 10%.”
Aligning employee and shareholder interests
With a basic explanation of EMI covered, the discussion moved on to how EMI schemes can be sold to both shareholders and employees.
As granting shares to employees dilutes the value of existing investors’ shares, employees' and shareholders’ interests are sometimes portrayed as in opposition.
Eager to dispel this misconception, Jerry argued that the EMI scheme helps align employee and shareholder interests, as both parties benefit from the success of the company. Invested employees add more value to a business, increasing both the share price and the return on a shareholder’s investment.
While explaining this concept to investors may occasionally be necessary, most professional investors already understand the rationale behind share options.
When it comes to convincing employees of the benefits of share schemes, Jerry believes the tax advantages are your most valuable tool.
“As an employer, you’re saying ‘we hope that in five years you’ll be able to access a greater sum of money and only pay 10% tax.’”
Explaining EMI mechanics, schedules and structures
While all full-time employees qualify for the scheme, part-time employees must work either 25 hours per week or dedicate more than three-quarters of their working week to the business.
Moving on to EMI structures, Jerry gave us a quick rundown of exit-only schemes.
“Exit-only is a very popular vesting structure, by which employees can only buy their shares when the company is sold or traded publicly. This structure focuses everyone in the scheme on building up company value towards a sale.”
Exit-only structures are typically contrasted with time-based schemes. Already widely used in the US, time-based structures are becoming increasingly common in the UK.
“A time-based structure will typically have a vesting schedule spread over four years, with employees able to convert their options gradually over that period.”
When it comes to bigger organisations, Jerry suggested a compromise may be the most sensible path forward.
“A bigger company might consider combining the two structures, offering exit-only share plans to the majority of employees, and time-based share plans to senior management hires.”
HMRC and company valuations
Though establishing an EMI scheme doesn’t necessarily require HMRC’s involvement, most experts strongly recommend applying for HMRC approval of your valuation proposal. Without approval, there is no certainty over how tax will apply to the shares granted.
The setup process takes around six weeks, with three to four weeks spent waiting for HMRC’s confirmation. Your valuation can be performed in several ways, but often involves taking the price per share established when your company last received outside investment.
This price is then adjusted to take into account the differences between investor and employee shares. Jerry went on to explain how this benefits employees.
“Investors might have received tax relief on their shares, been given a seat on the board or their shares may have liquidation preferences. All of these factors allow you to downgrade the employee share price and get a better deal for employees, fixing the tax they pay at a lower rate.”
To emphasise the extent to which this can lower share prices for employees, Jerry closed by sharing a recent case in which one of his clients had a 50% employee share price discount approved by HMRC.