Employee Incentives

Share options

Share options give employees a right in the future to acquire shares, usually if certain conditions are met. These are a very popular way to incentivise employees. Until an option is exercised, the holder is not a shareholder and has no control of the company through voting rights, no power to attend shareholder meetings and no right to dividends. It is also much easier for an option to fall away (for example, if an employee leaves) compared to the physical recovery of shares.

Broadly, options fall into two categories. Those exercisable immediately prior to an “exit event” (such as a sale or listing), meaning employees hold shares for a few seconds and then and those exercisable once a certain amount of time has passed (or some other trigger event occurs). In addition to the standard (and very flexible) “unapproved option” the government offers employers a number of alternatives with tax advantages. These come with a few restrictions and qualifying conditions, but if you do qualify, they are generally better choices.

EMI option

In our experience, the most popular form of option for companies that are not particularly large is an EMI (enterprise management incentive) option. It is very flexible and offers material tax advantages.

When an option with no tax advantages is exercised, employment tax is owed on the difference between the value of the shares at the point of exercise and the amount employees pay for them. Very broadly, if the option is exercised on an exit event such as a sale the tax will be due via PAYE (income tax and national insurance will be due – both employer and employee). If the option is exercised when no exit event is imminent, often just income tax will be due, payable by the employees through self-assessment (though there are other circumstances that can convert this to a PAYE charge).

By structuring the option as an EMI option, employees essentially exchange these employment taxes for capital gains tax. From the employee’s point of view, structuring an option under EMI rules means they could walk away with roughly twice as much cash after tax (compared to an unapproved share option). The tax advantages are so strong that (under tax rates in force at the time of writing) EMI options are tax negative once you factor in the corporation tax deduction available to the company.

In our experience, EMI options are very often the best sort of incentive for employees and a very strong way to help retain employees and encourage them to use their best efforts to grow a company. Your company does need to be below a certain size however, share options cannot be granted by a subsidiary company and the company must carry on the right sort of trade.

Company share option plans

These can be a good choice if your company is too large to use an EMI scheme. The tax benefits are broadly the same as with EMI, though there are greater restrictions over what you can offer. Share options cannot be granted at a discount for example, there is a much lower cap on the value of options you can award staff and there is a three year holding period before the tax advantages crystallise. Importantly however, the same conversion from employment taxes to capital taxes applies.

Save as you earn schemes / share incentive plans

These are a little different. Both are “all employee” schemes, meaning you have to offer them to everyone (with some limited exceptions). EMI options and company share option plans can be offered to chosen staff only.

Broadly, a save as you earn scheme lets staff save a certain amount each month which they can use at the end to buy shares, or they can instead take out their savings as cash. It can allow for tax free interest, or the acquisition of shares at a discount, and the employee can decide at the end what they would rather do (often guided by the value of shares at the time).

A share incentive plan lets you give a relatively small number of shares to employees for free and lets employees acquire shares from their pre-tax pay. While not an “option”, it has been included here as the fourth tax advantaged incentive the government offers.

Outsourcing

Instead of giving employees share options, you could can be given actual shares. While it can be harder to recover actual shares, it can sometimes be a more powerful incentive for staff to hold physical shares as opposed to a right to acquire shares in the future. This is not entirely logical, but emotionally the incentive can feel more “real” for employees.

Ordinary shares

Employees can be given some of the existing shares in the company. They might pay for these, or be given them for free. This is a relatively cheap and effective way to incentivise employees, but it has down sides. Do you want these employees being able to vote on company issues? Are you prepared to try and recover these shares should the employee leave? Very often, while this might work for one or two employees, it is impractical if several are to be incentivised.

One material down side of giving shares can be tax. If the company has value, unless employees pay full price for their shares, they will suffer a “dry” tax charge (meaning they incur tax despite receiving no cash to pay the charge). This often has the opposite effect to incentivising employees. The receipt of shares is a form of remuneration and still subject to tax.

Growth shares

Growth shares resolve some of the disadvantages set out above. Growth shares are a special new class of shares, with slightly different rights. They share in the future growth of the company, not the existing value, and therefore have a much lower value when given (and therefore a much lower tax charge is incurred). Typically, the shares won’t be able to vote, and often have no dividend rights (though this is flexible).

Growth shares, in our experience, are the second most popular form of share-based incentive behind EMI share options. Growth shares can be issued in subsidiary companies, they can be issued to non-employees, the size of the company is not a barrier and there are no prohibited trades. The tax advantages are not quite as good as with EMI options however, and it will always be more difficult to recover physical shares compared to the falling away of a share option.

Cash

As mentioned above, shares are only a good incentive if they can be turned into cash (or if they allow receipt of dividends). Sometimes, the simplest and most well understood incentive is best – a cash bonus. That are different ways this can be structured – a “phantom share scheme”, for example, can pay cash linked to share value (incentivising employees to grow the company). A “long term incentive plan” can be set up which either pays cash or shares (or a combination of the two) over time.

Employee Ownership Trusts (EOT)

Selling your company to an employee ownership trust (EOT) offers an alternative to a sale to a trade buyer or private equity house, an IPO or a management buyout.

An EOT is a trust set up for the benefit of a company’s employees. Following formation, the EOT buys the company. Perhaps the most famous example of an employee owned business is John Lewis.

The original shareholders of the company sell their shares to the EOT and after the sale the majority shareholder (perhaps the only shareholder) of the company is the EOT.  The employees can then begin to share in the company’s success as indirect owners of the company, which is a great way to incentivise them. Sale proceeds are typically funded from cash gifts by the company to the EOT, which the EOT in turn pays on to the selling shareholders.

There are significant advantages and some disadvantages for you when comparing a sale to an EOT to alternative sale structures, to find more about them access our EOT brochure by clicking here and read a case study here.

Employee Ownership Trusts (EOT)

The impact of different schemes can best be shown through an example. Assume a company decides to incentivise a single member of staff (“Joe”) in the following scenarios. In each case, 1% of the company is worth £30,000 at the time the decision to incentivise is made, and is worth £500,000 when the company sale takes place 5 years later:

1. Through an EMI share option

Joe is given an EMI option over 1% of the company shares with an exercise price of £30,000 (it could be less, but for simplicity we will set it at this value). 5 years later he exercises 5 minutes before the sale of the company completes (in reality a director might exercise for him under a power of attorney during the completion meeting for the sale). Joe sells for £500,000. £30,000 is netted off to cover his exercise price. Joe owes CGT through self assessment, he likely qualifies for a 10% rate thanks to “business asset disposal relief”. Joe pays £47,000 CGT and walks away with £423,000 (we have assumed no CGT annual allowance, for simplicity). The company gets a corporation tax deduction worth £89,300.

2. Through the purchase of ordinary shares

Joe buys the shares for £30,000 (or is given the shares and must pay income tax via self-assessment, depending on his tax bracket that might be in the region of £12,000 (assuming a higher rate tax payer)). On sale, Joe pays CGT on his gain of £470,000, but the relaxation of “business asset disposal relief” rules for EMI options (that removes the requirement to hold at least 5% of the company) doesn’t apply and Joe pays 20% CGT, £94,000. The company gets no corporation tax deduction, Joe walks away with £376,000 (and was £30,000 out of pocket for a few years).

3. Through growth shares

The growth shares are set up with a small “hurdle” (gap before they begin to accrue value) which depresses their current value to £300. Joe pays this (or suffers around £120 tax). On sale, Joe receives the growth above £33,000 (£3,000 being the “hurdle). Joe pays CGT of £93,340 and walks away with £373,360 (a further £33,000 (before tax) is shared amongst other shareholders on sale).

4. Through an unapproved share option

Joe is given an unapproved option over 1% of the company shares with an exercise price of £30,000 (it could be less, but for simplicity we will set it at this value). 5 years later he exercises 5 minutes before the sale of the company completes (in reality a director might exercise for him under a power of attorney during the completion meeting for the sale). Joe sells for £500,000. £30,000 is netted off to cover his exercise price. The company owes PAYE, to cover its own employer NIC it pays Joe £408,518 of his £470,000. Joe pays 3.25% NIC and for simplicity assume a flat 45% income tax. Joe walks away with £211,408. The Company gets a corporation tax deduction worth £89,300

5. Through a cash bonus on completion

Joe is allocated £470,000. After deducting the employer NIC costs and then the PAYE deductions, exactly the same sum as the unapproved share option is left – £211,408. The same corporation tax deduction as above is due.

As can be seen, EMI options leave the employee with the highest proceeds as well as leaving the company with the (joint) highest deduction.

Key contact

• Emer Hughes – Legal Director

Vesting Period

It is very common that when an executive leaves employment they will lose the benefit of share schemes in a number of ways:

• Awards typically vest over a specified period from the date of grant (say 3 or 5 years).  Unvested awards are typically lost on termination of employment.
• Vesting often occurs by monthly instalments on a “straight line basis” over the vesting period.  However, sometimes there may be an initial period where there is no vesting until the end of, say, year 1 or 2.
• The precise trigger can vary.  The relevant date might be: (a) the date when employment actually ends; or (b) the date when “active employment” ceases (meaning that time on “garden leave” would not add to vesting); or (c) the date when notice of termination of employment is given by the executive or the employer (whether or not the executive subsequently works through their notice period or is on “garden leave” or paid in lieu of notice).

Good / Bad Leaver Provisions

Typically, the circumstances of an executive leaving the company will impact upon the value they will receive.  This might include:

Bad Leavers:

• Lose all unvested awards
• Have vested awards taken off them at a disadvantageous price, say, the lower of fair market value and the cost (if any) paid by the executive to acquire the awards

Good Leavers:

• Retain the full benefit of their vested awards
• Have some prospect of getting the benefit of unvested awards e.g. at the discretion of the Remuneration Committee

There is considerable variety regarding the definitions of Good / Bad Leavers.  Sometimes there may even be a third category of “Intermediate Leavers”.

Factors which may be used in the definition of Good / Bad Leaver include:

• Whether the reason for termination was one or more of certain circumstances such as:
  • Redundancy
  • Death
  • Ill health
• Whether the executive was wrongly dismissed.  Wrongful dismissal has a specific legal meaning – it refers to a dismissal in breach of contract, which usually relates to a dismissal without notice when notice should have been given (which may be in a situation where the employer says that the executive could be summarily dismissed because they had committed gross misconduct and the executive disputes this)
• Whether the executive was unfairly dismissed.  This phrase references the regime under the Employment Rights Act 1996 where an employee may only be fairly dismissed where the employer:
  • Dismisses for one of a defined group of potentially fair reasons – redundancy, misconduct, capability etc. (substantive fairness); and
  • The employer adopts an appropriately fair procedure (procedural fairness)
• Some schemes differentiate between substantive fairness and procedural fairness.  Employers may consider that an executive should not effectively convert from being a Bad Leaver to a Good Leaver simply because of some procedural slip up by the employer.
• Whether the executive engages in detrimental conduct such as:
  • Breach of post-termination non-compete or non-solicitation provisions
  • Making disparaging comments about the company or its directors, employees and/or shareholders

Compensation for Loss of Rights

If an executive is dismissed before they have vested awards, they potentially stand to lose out on very substantial amounts.  If may be that an executive has accepted a lower salary in the expectation that they will receive value from their awards.

The claims which executives have on termination of employment can broadly be divided into two / three types:

• Contractual claims
• Statutory claims:
  • unfair dismissal under the Employment Rights Act 1996 and/or
  • unlawful discrimination on grounds of a protected characteristic (e.g. sex, race, nationality, disability, sexual orientation, age, religion / belief etc.) under the Equality Act 2010

Contractual Claims

In theory, where an executive is dismissed, they might be able to claim for awards which would have vested during their notice period.

However, it is very common that share schemes contain provisions seeking to exclude claims.  These are sometimes referred to as “Micklefield clauses” after the case of Micklefield v SAC Technology Ltd [1990] in which the following wording was upheld by a Court:

“If any option holder ceases to be an executive for any reason he shall not be entitled, and by applying for an option an executive shall be deemed irrevocably to have waived any entitlement, by way of compensation for loss of office or otherwise howsoever to any sum or other benefit to compensate him for the loss of any rights under the scheme.”

Considerations in relation to Micklefield clauses:

• Careful drafting is needed by the company.  The clause will be construed in favour of the individual executive, following the general principle of contract law that an exclusion clause that is ambiguous or uncertain will be construed against the party trying to rely on it (Levett v Biotrace International Plc [1999]).
• They may not apply where the company acts in bad faith.  In Parmar v HSBC Private Bank (UK) Ltd [2018], the High Court declared that such a clause was not sufficient to exclude liability in the event of “bad faith or something akin to it, such as discrimination or perversity”. The clause in question attempted to exclude liability, even where the bank’s decision, omission or discretion was irrational and the court found that even an express reference to irrationality would not be sufficient to exclude liability for the bank’s actions in such circumstances.

Statutory Claims Generally

Contractual provisions of the type mentioned above (“Micklefield clauses”) typically won’t work to exclude statutory claims, not least because both the Employment Rights Act 1996 and Equality Act 2010 have sections stating that parties cannot contract out of the statutory rights.

Thus, where an executive is unlawfully dismissed, they can be compensated financially for the loss of awards. Employment Tribunals don’t have the power to award the actual shares or options, only money.

The Employment Tribunal will have to do its best to estimate the value of the awards which have been lost as a result of the unfairness, taking into account the executive’s duty to mitigate loss (i.e. to take reasonable steps to secure new remuneration).

Unfair Dismissal Claims

In the absence of there being unlawful discrimination, or the dismissal being as a result of the executive making a public interest disclosure (whistleblowing) there is a cap on the level of unfair dismissal compensation at about £90,000.

In a recent case (Jones v JP Morgan Securities plc [2021]), the executive effectively got round this cap by seeking and being awarded reinstatement by an Employment Tribunal. A reinstatement order will generally require the employer to make up all the executive’s lost salary and benefits for the period between dismissal and the date of reinstatement (sections 114 and 115, ERA 1996). This sum is not subject to the usual statutory cap on unfair dismissal compensation.  In this case, because the Tribunal hearing took place months after the dismissal, this enabled the executive to be compensated in full in respect of the discretionary bonus which he would have received in the intervening period.

However, Mr Jones’ case is the exception and is unlikely to become a norm.  Re-employment orders are extremely rare in practice – they are made in less than 1% of cases.

Discrimination and Whistleblowing Claims

If an executive wins a claim for discrimination and/or whistleblowing, they will be entitled to be compensated for their full losses, including in relation to share and LTIP awards.  In practice, remedies hearing in such cases can be hard fought as there can be considerable scope for dispute as to how to value share awards.

Exercises of Discretion

Plan Rules may contain discretions for the company.  For instance, there might be a discretion to provide some or all of the unvested awards to a Good Leaver.

Companies often have a discretion under the rules of a share plan to allow share awards to be retained or share options to be exercised, even after termination of employment.

An executive may be able to claim damages for the loss of a share award or option arising from a breach of contract caused by the way in which this discretion has been exercised (or not exercised).  Any “Micklefield clause” will probably not protect the employer, as the loss arguably arises from the breach of the company’s contractual duties in exercising its discretion, and not from the termination of employment itself.

The law in relation to the exercise of discretions is developing, following the Judgment of the Supreme Court in Braganza v BP Shipping Limited [2015].  In essence, any discretion must be exercised rationally and consistently with its contractual purpose.  This is an exception to the general rule of English law that contractual rights are enforceable regardless of whether they are exercised in a reasonable or unreasonable way. To comply with the duty of rationality, the decision-maker must:

• Ask the right question
• Take account of relevant matters
• Ignore irrelevant matters
• Avoid a result so outrageous that no reasonable decision-maker could have reached it

Applying these principles, in the case of Daniels v Lloyds Bank Plc [2018], the High Court held that a bank did not have the power to amend the terms of existing awards under a long-term share incentive plan to apply a malus clause. Even if the clause did apply to existing awards, the power to reduce awards under the malus clause could not be exercised where shares had already vested under the plan.

Unfair Dismissal Claims

• Adrian Crawford – Partner

Further information

At Kingsley Napley we pride ourselves in the collaborative and joined up way in which diverse teams work together to advise our clients and find practical solutions.

If you would like more information or require advice in relation to any of the above areas, please contact a member of our employee incentives team.