Our client was invited to become an employee shareholder in his employer company. The employer specialised in designing robots. He was not sure about the potential of seeing any value. There was a concern about being asked to sign a “Section 431 election”.
The documentation issued by employers when they gift shares to employee shareholders can be long and very legalistic. It is difficult for an employee to understand the meaning and assess the potential. Without knowledge of the implications the employees cannot quantify the real benefits and understand risk.
Our client was offered a mix of low salary and free shares in the business. He was unsure whether it was a good deal.
The discussion enabled us to recommend areas where the employee’s potential for receiving value could be improved.
How to assess the potential of shares
We explained a number of key issues an employee shareholder should consider. The major issues were:
What happens if the employee leaves employment?
The employee shareholder conditions set out in the shareholders agreement provided for the compulsory transfer of shares on leaving employment. There was a price formulae in the shareholders agreement setting out the price at which the shares will be bought back on departure.
The shareholders agreement made a distinction between a good and a bad leaver. Leaver clauses are common. If our client left the company because of death or disability, he would be considered a good leaver. As a good leaver he would receive a fair value for his shares on departure. But, if he resigned or left for any other reason, including redundancy, as drafted he would be a bad leaver. As a bad leaver he would get nothing back. We set about changing this.
We negotiated a better position for the client. If he stayed with the business for over a year he would always be considered a good leaver. The only exception was dishonesty which we advised was a reasonable event to attach to a bad leaver.
What happens if a dividend is paid?
The shares being given to the employee were a separate class of shares. This meant that he could potentially receive a lower rate of dividend than other shareholders. We recommended that it was agreed that the dividend voted on his shares would always be equal to that voted on other classes of shares. A perk of being a shareholder is that under current legislation the first £5,000 of dividends is tax free.
What happens if the business is sold?
The shareholders agreement included drag along provisions. If the business was sold the employee shareholder would have to participate in the business sale. He could not block the sale even if he did not like the sale price.
We recommended including tag along provisions. Tag along enables a minority shareholder to piggyback if an offer is made to the majority shareholder. They protect the employee shareholder.
How much tax is payable on receipt of the shares?
Gift of shares was taxable as income for the employee shareholder. Shares have a taxable value in the eyes of HMRC.
We suggested the employer obtains agreement from HMRC as to the taxable value. This was to give our client certainty over how much tax he has to pay on the gift of shares. We suggested that the employer loans the money needed to pay the tax due on the gift.
We warned the client that once the income tax was paid there will be no refund if the shares go down in value. We persuaded the employer to give an indemnity to cover the risk of overpaying tax.
Should an employee shareholder sign section 431 election?
Section 431 election is a document by which employee shareholder and employer choose to pay tax on the unrestricted tax market value of shares at the time of grant regardless of price paid for the shares by the employee shareholder. Signing a section 431 election secures certainty on the tax treatment for the employee as illustrated below. We recommended that the section 431 election was signed.
Section 431 election – Illustration
If no section 431 election is entered into there is a risk that HMRC assesses the shares at a higher value. For example, if HMRC place a 20% undervalue on the shares, then 20% of shares sale price will be subject to income tax on sale. As we explain below a section 431 charge can reduce the overall tax burden.
If a section 431 election is signed and tax paid on the gift of shares there will be no income tax or NICs on sale of shares. No nasty surprises for the employee shareholder. The effect of the section 431 election is that the growth in value is assessed to capital gains tax. Capital gains tax is lower than income tax and national insurance.
What happens if the employee wants to set up his own business in the future?
The employee shareholder was bound by anti-competition restrictions. He could not set up in competition for a year after he left. We successfully negotiated the restrictions down to 6 months.
Can the employee shareholder stop his shareholding from being diluted?
The employee shareholder was worried that new investors could dilute him in the future. His shareholding would drop below entrepreneurs’ relief 5% threshold.
We explained that all shareholders are at risk of dilution. Whilst legally possible, it is rare to ring fence shareholdings. The idea is that new shares are issued to improve the value of the company. Whilst the shareholding may drop terms of the total percentage of the company owned – following dilution the holding is over a more valuable company. As a work around we suggested the employee shareholder was given some powers of veto to prevent certain actions being taken without his approval:
- Bank borrowing over £50,000;
- The company giving a guarantee or a loan to anyone outside the normal course of business;
- The board approving a dividend that exceeds 40% of post-tax distributable profits; and
- Appointment of a director or an employee whose salary would exceed £100,000 gross per annum.
How much influence does the employee shareholder have?
The employee shareholder was offered 10% equity. Minority shareholders do not have a lot of power. A 10% shareholder could not block a special resolution. He could however:
- Propose a resolution at a general meeting;
- Ask for a general meeting be held;
- Require the company circulates to shareholders a statement relating to a matter included in a proposed resolution to be discussed at shareholders’ meetings;
- Prevent the deemed re-appointment of the company’s auditor; and
- Block holding a general meeting at short notice.
Catherine Gannon and her team regularly advise both employees and directors and their employers on share rights. The team focus on private companies in the UK and the implementation of arrangements for UK subsidiary undertakings of companies controlled outside of the UK.