Retaining skilled employees presents a significant challenge in the fast-paced technology sector. This is due to the high demand for talent and the transient nature of the workforce.
Tech companies must ensure that their valuable employees remain incentivised to stay, facilitating continuous growth of the business at a fast-moving rate. However, high-growth businesses often face limitations in rewarding employees through traditional means like salary hikes and bonuses, given their high cash burn rates.
Equity incentives emerge as a valuable tool for retention, offering several advantages, including:
- Alignment of interests: Equity incentives align the objectives of employees with those of shareholders, fostering a collective drive to grow the business’s value.
- Long-term retention: Unlike bonuses, equity rewards are tied to, and reward continued employment, encouraging loyalty.
- Potential for value realisation: Tech firms usually have clear exit or investment plans, providing employees with opportunities to realise value from their equity awards.
While equity awards are subject to taxation in the same way as a cash bonus, there are ways for tech companies to structure equity plans more tax efficiently.
Enterprise Management Incentive (EMI)
EMI schemes are widely favoured in the tech industry. They are used as a means of providing employees with options to acquire shares in the future. The EMI scheme is popular due to its tax efficiency and the flexibility it offers in terms of structuring.
Key features of the scheme include:
- Options issued under the EMI scheme incur no immediate tax implications
- Businesses negotiate the market value of shares with HMRC, often applying a significant minority discount
- Upon exercise, no tax is usually payable if the exercise price aligns with the agreed market value
- If the options or shares are held for at least two years, any profit made from selling them later on will be eligible for capital gains tax, which could be as low as 10%
- When employees exercise their options, the company can receive a potentially valuable corporate tax deduction equal to the difference between the exercise price and the market value
How an EMI works
In its most basic form, EMI can be employed by exercising options just before an exit or investment event, allowing the acquired shares to be sold immediately. This method, known as a cashless exercise, doesn’t require any upfront investment from the employee. Instead, the exercise price is deducted from the proceeds of the share disposal by the company.
Alternatively, an EMI scheme can be structured to allow options to vest or be exercised at various intervals. These options are often contingent on factors such as length of service or meeting performance criteria.
One potential drawback is the requirement for employees to invest in exercising their options. This may lead to a dilution of control and dividend rights for existing shareholders. However, individual circumstances vary, and sometimes both parties prefer employees to hold physical shares.
Compared to alternatives like bonus awards or issuing shares directly, the 10% tax rate associated with the EMI scheme is notably advantageous. In contrast, unapproved options could incur tax rates as high as 47%, along with employer National Insurance Contributions (NICs).
Tax implications explained
The comparison below demonstrates the tax implications for an individual receiving a grant of EMI options versus unapproved non-tax advantaged options. In this scenario, the company is valued at £2m with 100 shares in circulation. The grantee, Individual A, is given options to acquire 5 shares valued at £100,000 on the grant date.
To compare the tax impact, we assume that the options will be exercised just before an exit event when the company value has increased to £5m. Although this example overlooks corporation tax relief, it highlights the tax advantages of EMI options.
| Company value at the time of option issue | £2,000,000 |
| Total number of shares | 100 |
| Value of options (5 shares) | £100,000 |
| Agreed value with HMRC, including minority discount (70%) | £30,000 |
| Exercise price per share | £6,000 |
| Market value per share at the time of exercise and sale (£5m/100) | £50,000 |
On grant of options: no tax charge for either EMI options or Unapproved options
On the exercise of options, assuming that this is aligned with an exit event:
| Unapproved options (£) | EMI options (£) | |
| Market value on exercise | 250,000 | 250,000 |
| Less: exercise price | (30,000) | (30,000) |
| Gain | 220,000 | 220,000 |
| Income tax @ 45% | 99,000 | |
| Employees NIC @ 2% | 4,400 | |
| Employers NIC @ 13.8% | 30,360 | |
| Capital gains tax @ 10% | 22,000 | |
| Total tax payable | 133,760 | 22,000 |
Growth shares
Another tax-efficient option and alternative to EMI is the use of growth shares. These offer employees a share in the company’s growth without rights to its current value. These shares are considered to have little or no value at the time of issuance, resulting in a minimal tax liability for the employee. Any increase in value from that point onwards will be subject to capital gains tax rates, which are expected to be around 20%.
Psychologically, employees may find it appealing to own actual shares from the moment they are issued. Even if these shares are typically issued without voting or dividend rights.
Implementing a growth share scheme, on the other hand, can be more complicated. This requires creating different share classes and may necessitate changes to the Articles of the company, which may not be necessary for an EMI scheme. As a result, growth share schemes are often utilised in situations where a company may not qualify for the EMI regime. However, it is feasible to include growth shares as an option within an EMI scheme.
Potential consequences and considerations
Implementing equity schemes requires careful planning and consideration.
- Employee understanding: It’s crucial for employees to fully comprehend the benefits and implications of equity rewards to ensure their effectiveness
- Compliance: Proper implementation of schemes, particularly EMI, requires adherence to various conditions and rules to avoid unintended tax consequences
- Strategic planning: Businesses must plan well in advance of potential exit events to maximise tax efficiencies and leverage the benefits of equity incentives
Key recommendations for tech businesses
It’s imperative for businesses operating in the technology sector to prioritise retention strategies for their key employees. They must ensure they’re not caught off guard by talent attrition. Seeking expert advice and implementing the most suitable incentive scheme tailored to their specific circumstances is also crucial for success.
Equally important is ensuring that employees fully comprehend the scheme and are genuinely motivated by its potential benefits. Moreover, leveraging the tax efficiencies promoted by HMRC through schemes like EMI can further enhance the attractiveness of equity incentives. By adhering to these principles, tech companies can not only retain their top talent but also foster a culture of loyalty and sustained growth.
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