Mary Tierney, Tax Director, BSC ARCS ACA CTA
As a tax advisor who deals with many potential high growth start-ups, there is one issue that crops up frequently where it is always challenging to find workable and effective solutions.
Imagine the scenario, there are three friends, Bob, Anne and Chris who have a whizz bang idea for a new material, a cotton feel material made from recycled plastic. They are very excited and have had discussions with various technology start-up funds who are keen to invest.
As good friends they all trust each other, and Bob and Anne form the company Baccab Ltd and hold the shares 50:50. They don’t issue shares to Chris at the start as he was tied into his current employer for another year, but they always knew he would join them when the time was right.
They form the company and take in investment, diluting their shareholdings to 45% each with investors, who are all Seed Enterprise Investment Scheme (SEIS) qualifying, holding 10% of shares. The company is valued at £1,500,000 for the purpose of this first fund raise.
Everything goes well to begin with, the SEIS certificates are issued promptly, and they start to spend the funds on developing the product. After a few months however the three decide to reduce Bob’s shareholding and issue shares to Chris and instruct their accountant to make this happen.
This gives us a raft of issues to address:
- The company was valued for the purpose of the fund raise and for tax purposes that’s HMRC’s starting point for the value of the shares.
- If Bob disposes of his shares, there are potential capital gains tax and if at an undervalue, inheritance tax implications.
- If an existing or future employee increases the % of company shares they hold, then there is an income tax charge on them based on their increase in value.
There are two issues that must be looked at separately.
- How to reduce an employee’s shareholdings
- How to issue an employee shares without a penal tax charge
Dealing with the first issue, its unlikely that the company will have the distributable reserves to repurchase the shares, so either another shareholder purchases the shares with possible income tax issues for that shareholder, or often the practical solution is to convert the “lost” shares to deferred shares. If this is done, there are still potential value shifting issues to negotiate for continuing shareholders and great care is required in introducing a class of deferred shares into the shareholding structure as shown by the case of Flix Innovations.
Flix created a class of “deferred shares”. On a liquidation the ordinary shareholders were due the nominal value of their shares prior to the very minimal value due to the deferred shares. The total value of the preferential right was £933, which represented only 0.05 per cent of the market value of all shares but which was sufficient for HMRC to deny EIS relief on the ordinary shares. This can be avoided by appropriate drafting but is a salutary tale.
Next is the question of how to award shares to an existing employee or director without an upfront “dry” tax charge. Options here include:
- To issue new shares with a tax charge arising.
- Issue options over shares, if these are non-tax favoured options there is no tax charge upfront but as an employee or director an income tax charge on the value of these shares will arise on exercise at the value at the date of exercise.
- For “full time” working employees, share options under an Enterprise Management Incentive (“EMI”) scheme can be considered. There is not space in this article to go into all the benefits of EMI, but this is often quite an attractive option.
- Growth shares can be issued, that is shares that only return capital value on a sale at a premium to the current company value, on the basis that the value of these shares is reduced by this hurdle, and so reduces any upfront tax charge.
- Nil paid shares could be considered, full market value is paid, but left as “unpaid share capital”. If, however the company fails, there would be a call on this unpaid share capital.
Or a combination of the above.
The morale of the story is for start ups to think very carefully about who initial “founder” shares are issued to and, as far as they can, to do a bit of crystal ball gazing and consider future “what if” scenarios and how they might be dealt with. In the real world however when the focus is on getting an idea up and running, quite understandably the share cap table takes back seat, and I expect to be dealing with these knotty issues for some time yet.
If you have any questions around issuing Limited company shares, please contact us.
