Growth shares are a special class of shares created (usually) by unlisted companies to provide equity incentives to management and key employees.
They reward participants for the growth in value of the company above a “threshold” or “hurdle” which is specified on issue.
Most unlisted companies which do not meet the conditions necessary to grant tax-advantage share options or who wish to offer incentives to non-employees (such as consultants and non-executive directors) should consider structuring their equity incentives using growth shares. This paper sets out how these arrangements work.
What is the typical arrangement for an unlisted company?
Suppose Company A wishes to incentivise a new manager by awarding her 3% of the issued share capital. Company A has 100,000 ordinary shares in issue of 1p each with an estimated market value of £10 per share (ignoring minority discounts and valuing the company as a whole at £1 million). The value is benchmarked by reference to a recent external investment in which the investor paid £10 per ordinary share.
If the manager acquired 3,000 ordinary shares she would need to pay market value of £30,000 for them or otherwise trigger an income tax charge (and possibly National Insurance contributions, depending on the circumstances) on the difference between the market value of the shares and the amount paid. The up-front cash costs would make the award of ordinary shares unattractive. Company A could instead lend the subscription monies or issue the shares on deferred payment terms but, in either case, the manager would be required to take a real commercial risk which is also unattractive.
The arrangement could instead be structured using growth shares as follows:
- The articles of Company A are amended to create a new class of growth shares of 1p each with no rights other than to participate in sale proceeds on an exit (or distributions on a winding-up) pro-rata with ordinary shares but only after ordinary shares have received a hurdle amount of £10 per share.
- The new manager is required to enter into a subscription agreement which requires her to pay 1p per share for the growth shares. The growth shares are issued fully paid so the manager has no further obligation to pay for the shares.
- The subscription agreement contains a vesting schedule and a call option which gives the company a right to purchase unvested shares for 1p each if she leaves for any reason and a right to purchase vested growth shares at fair value (or 1p should the manager resign, be dismissed for cause or breach non-compete obligations post-cessation).
- The manager is required to make an election pursuant to section 431(1) ITEPA 2003 to pay income tax on the “unrestricted market value” of the growth shares (which is, broadly, the value of the shares for tax purposes ignoring the vesting and forfeiture conditions) within 14 days of acquisition.
- Company A takes professional advice to the effect that the up-front value of the growth shares is no more than par (because any rational purchaser would pay £10 less for the growth shares with a hurdle of £10 than ordinary shares and nothing material has occurred since the recent investment which would affect the value of the company). In other words, if Company A were sold for £1 million just after the manager received the growth shares, she would not receive any of the sale proceeds so the growth shares have no “intrinsic value” as at the date of acquisition.
- The manager declares the receipt of growth shares in her tax return and her tax inspector accepts the growth shares have a market value of no greater than their nominal value (1p per share) so there is no income tax to pay as a result of making the election (as the manager paid market value for the shares).
- Three years later Company A is sold for £10 million. There are 100,000 ordinary shares in issue and 3,000 growth shares held by the manager. The first £1 million of sale consideration is paid to the holders of ordinary shares and the remaining £9 million is paid pro-rata to ordinary and growth shareholders. The manager receives £9 million / 103,000 = £87.38 per growth share or £262,136 in total. All gains are taxed as capital at the top rate of 20% so she pays CGT of £52,427 ignoring annual exemptions.
Note: The hurdle has a real economic effect as the manager does not receive the first £10 per ordinary share so any rational purchaser would pay £10 per share less for growth shares with a £10 hurdle than they would pay for ordinary shares. The arrangement is commercially similar to an option to acquire ordinary shares at a £10 strike price but is more tax efficient than a non-tax advantaged option.
For more detailed guidance on Growth Shares please click here.
 Note: This example assumes HMRC will agree the unrestricted market value by deducting the hurdle from the value of ordinary shares. Some inspectors, however, take the view that growth shares have a “hope” value over and above the “intrinsic” value when compared to ordinary shares. If so, it may be necessary to agree the growth shares have a higher value (resulting in some up front tax charge) or to set the subscription price in excess of par to reflect the hope value.