The valuation of growth shares for employee motivation

Background

Key employees often drive the growth in value of a company and arguably one of the best ways to motivate them to do this is to give them a share in this increase in value and ‘growth’ shares are a great way of achieving this.

However, either the receiving employee will need to pay market value for the growth shares or HMRC will require tax on the receipt of any growth shares at undervalue.

At their most basic, growth shares are a separate class of incentive share that entitles the holder to benefit in the future growth in value of a business, but typically only on a company exit (sale) event.

The key difference between growth shares and ‘ordinary’ shares is that the recipient only usually benefits in the value of a business above a set ‘hurdle’ level rather than in the whole business value. Growth shares are flexible, tailored, and can even be set up as part of a tax efficient EMI scheme.  Using growth shares, the existing value in the business can be preserved for the original shareholders.

Growth shares are perhaps best illustrated in the (fictitious) example of TopTech Ltd.  TopTech was established by Janet and Chris 10 years ago and now has a turnover of £10m.  The business is projected to continue to grow further with Janet and Chris looking to hire several senior people and exit the business in 5 to 8 years’ time via a sale to one of the global tech giants.

However, at present, TopTech is not able to pay top salaries for these new appointments. Janet and Chris also wish to ring fence the value they have created in the business today.

Janet and Chris believe growth shares will give them the flexibility to incentivise new and existing members of staff to grow, and ultimately sell, TopTech by offering a share of future value growth without devaluing their own hard work over the previous decade.

An added benefit compared to ordinary shares is that any tax due by the employee on the receipt of growth shares would likely be significantly lower than for equivalent percentage of ordinary shares, as the hurdle devalues the shares.  However, the hurdle does not entirely devalue the growth shares as these have an upside only (i.e. there is no loss to the holder if there is a fall in company value).

Valuation

Before a business issues growth shares it needs to establish the hurdle value or in some structures even multiple hurdle values.  This is the value beyond which the company must grow before holders are entitled to receive any value for their shares.  The current value of the business is often key in determining this value.  Once the company value is known and the hurdle value has been set, it is necessary to value the growth shares recognising the differential in class rights as compared against ordinary shares.

Valuations on issuing growth shares are therefore very different than, for example, valuing a business for sale, which will look to maximise value.

For tax purposes, the growth share valuation is based around a hypothetical transaction between a willing seller and buyer using an appropriate amount of information.  It will consider first the whole company value then the element attributable to the growth shares, which can involve complex calculations and modelling around the growth prospects of the business and the allocation of sale proceeds arising.  This can be particularly challenging where forecasts are overly aspirational or not available.

We at Kreston Reeves have developed a set of robust modelling tools to value growth shares for a true sale or to satisfy HMRC’s requirements.

If you would like to discuss your business, contact our team today.