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Shares for rights: an opportunity for private equity?

Stacks of One and Two Pound Coins, and Twenty Pound Notes Print publication

25/09/2013

The recent news that eight members of private-equity backed Whitworths’ management team are being offered “shares for rights” by their private equity owner may be an indication of things to come.

Background

Under the new scheme, contained in section 31 of the Growth and Infrastructure Act 2013 and which came into force on 1 September 2013, employees can give up their right to claim unfair dismissal (except for reasons that are automatically unfair, such as discrimination), the right to request flexible working, the right to statutory redundancy pay and certain other statutory employment rights, in return for shares in their employer (or its parent company) worth at least £2,000.

The scheme is open to all employees although clearly the scheme is better suited to senior employees than it is to junior staff.  Senior management are unlikely to bring an unfair dismissal claim in any event – and will have contractual protection – so have little to lose and potentially plenty to gain by agreeing to become an “employee shareholder”.  Anyone can apply for an “employee shareholder” position although they cannot be forced to accept the status if they do not want to.

It should also be noted that the only consideration that can be given by the employee for the shares is his or her agreement to be become an “employee shareholder”, as defined in the legislation.  If he or she is found to have given any other consideration they will not be an “employee shareholder”.

There are no restrictions on the class of share to which the scheme applies, the only requirement being that the shares are fully paid.  This means, for private equity, that the shares could be growth shares or sweet equity.  The requirement for the shares to have a minimum value of £2,000 (there is no maximum value) means that the scheme will be better suited for high growth companies which are already some way up their growth curve and will not be suited to those companies where the equity has little or no value.

The tax treatment

The first £2,000 worth of shares received are free from income tax and National Insurance contributions, but any value in excess of £2,000 will be subject to income tax and NICs, so there could be an immediate tax charge.

Any gain on a later disposal of the shares, up to a maximum of £50,000 valued (on an unrestricted basis) on acquisition, is exempt from capital gains tax.  To give an example: if X acquires shares worth £4,000 on day one, he would pay income tax/NICs on £2,000.  If he then sold the shares five years’ later for £100,000, because the value of the shares on acquisition was less than £50,000, there would be no CGT to pay on the gain of £96,000.

Administrative requirements

Following criticism of the scheme as potentially exploiting employees through having to give up their rights, extra safeguards have been built into the legislation.  The employer must explain in writing the rights that the employee is giving up and provide details of the shares being offered.  This will need to be in some detail; for instance, the legislation requires details to be given of any drag-along/tag-along rights and restrictions on transferability of the shares.  There is a seven-day “cooling off” period and employees must receive independent legal advice before they accept the offer, with the employer making a “reasonable” contribution towards the employee’s legal fees.

The shares will need to be valued on acquisition and the valuation will need to show a value of at least £2,000 for the shares being acquired and therefore there is potentially the additional burden and cost of obtaining a valuation to take into account.

Leavers

As in any private equity deal consideration must be given at the outset to the position on termination of employment and the drafting of “leaver” provisions.  The initial government consultation proposed that shares be bought back at a “reasonable value” where they are forfeited or surrendered in accordance with the rights and restrictions attaching to those shares.  However, the government response to the consultation confirmed that the precise terms of any provision requiring the forfeiture of shares held by employee shareholders, including as to valuation, should be left to agreement between the parties.  The legislation does not impose any requirement on the company to buy back forfeited shares nor does it preclude compulsory transfers to other shareholders or third parties.  This is welcome news for companies who will have the flexibility to impose their own good leaver/bad leaver provisions on employee shareholders, through the articles.  The government has not addressed the price to be paid on forfeiture so it would appear that shares that are forfeited on termination could be bought back for less than £2,000, although this is not wholly clear at present.

An opportunity

“Shares for rights” are not suitable for every employee or every company.  But for dynamic management teams in companies with significant potential for rapid capital growth, the benefits, particularly the CGT exemption, may be a real attraction and should be given very careful consideration.  The scheme could be very attractive to top earners who consider giving up certain rights for shares as a good trade off especially when they see a lot of potential for further growth.  In particular, the scheme could be appropriate for companies already on an established growth curve wanting to strengthen their existing management teams by incentivising key new members of staff through the use of the scheme.

 

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