Employee share schemes are a great way to reward and motivate staff. By giving employees a share in the company they are helping to build, you can reward their hard work in a meaningful and often tax-efficient way.
If you are selling your company, or looking to acquire a business, the existence of an employee share scheme can cause some wrinkles in the transaction. That’s why it’s important to understand ahead of time how the scheme works, and how employee shares will be handled in connection with the sale.
This article looks at employee share schemes in the context of a company sale, and how existing employee shares are affected.
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What different ways can shares be sold?
Shares in private limited companies cannot be sold on the open market, unlike shares of public limited companies - you can sell private limited companies to third parties in a number of ways:
- The management of a company can decide to buy out the existing owners. This is known as a management buyout. Management buy outs are typically funded by bank loans or by recourse to private equity firms.
- You can sell your company to another business, so your company becomes a subsidiary of that firm.
- You can offer to buy out all of the shareholders.
In addition, aside from normal trading, public limited companies can sell shares via a court-backed scheme of arrangement, or an offer can be made to buy shares using the provisions of the Takeover Code.
When a company is sold, the buyer and seller usually contract with each other using a document called a Share Purchase Agreement or SPA that will describe the terms of the sale.
What due diligence should be carried out as part of the sale?
Companies often offer shares or options for shares to employees as part of their overall compensation package, and these are known as employee share schemes. As well as incentivising staff who become part-owners of the companies for whom they work, share schemes often carry with them tax advantages.
When buying a company, it’s important to find out how many classes of shares and the number of shares (and options for shares) that exist, including whether any are held by employees, and the terms on which those employees hold their shares. You can find out this information from the company’s Articles of Association, the share scheme document and any shareholders' agreement.
Sometimes companies award special classes of shares to employee groups, mainly because they don’t wish to award them similar rights to other shareholders, like voting or dividends. In addition, employees may be required to give back or sell their shares if they leave, or if the majority shareholders want to sell. There may be employee options outstanding that give the right to employees to purchase or receive shares when they are exercised, and there may be special types of shares that exist like growth shares or employee shareholders shares.
The main purpose of due diligence is to enable you to find out as much as possible about the target company so you can put a value on it, to identify any risks involved in the transaction that may affect that value or cause you to want to pull out of the sale, and to give you information about the company culture and set-up so that you can operate it properly after completion.
The reasons for wanting to know about existing employee share schemes in the context of due diligence are:
- Employees will expect to sell their shares as part of the transaction, and there may be share options outstanding that will be affected by the sale.
- There may be tax implications associated with the schemes that could cause tax charges to arise (or reliefs to be lost) if the transaction goes ahead.
- You may want to continue with a similar scheme after completion.
- You’ll want to consult with affected employees in relation to the schemes.
What are the rights of employees/shareholders?
If employees own shares in a company being sold, they will usually want to sell their shares to the buyer. The terms on which these shares are sold will be described in the SPA. If there are existing share awards or options outstanding, you’ll need to find out if these have vested (in other words, that the employee can exercise the option to buy or receive shares), and whether the sale itself may cause these options or awards to vest, because, as a buyer, you’ll usually want to make sure you acquire 100% of all the outstanding shares in the target company.
Considerations of SPA
Although employees may own shares in the company for which they work, they don’t often have senior management responsibility so won’t be asked to make warranties in the SPA about the company being sold, although they may sign the SPA as a group of minority shareholders.
When will vesting occur?
The rules around when awards of shares or share options will vest will be described in the share scheme agreement or plan. Vesting normally happens just before or after the sale has completed. From the buyer’s perspective, it’s better to have awards or options vest prior to completion, both for tax reasons and to make sure that all outstanding shares are swept up by the sale, and so that the holders sign up to the SPA. Timing can be tricky, as all parties will need to be 100% sure that the sale will go ahead when the options and awards vest.
The best way to approach this issue is to communicate with the holders as soon as possible to tell them about the sale, to describe the vesting process, to explain how shares may be paid for (or if it’s possible to acquire shares without paying cash for them, known as a ‘cashless exercise’), any tax implications, and how the sales process will proceed.
Your lawyers will make sure that the sales process is tailored to take account of the employee share transactions, including using powers of attorney to sign the SPA on behalf of employees, and drafting the necessary documents so that options and awards vest just before completion. If, for any reason, the sale transaction doesn’t go ahead, the vesting can be set aside. If employees decide they want to exercise their options but don’t want to sell, they may be required to sell if the Articles provide for this.
What are the tax implications (depending on the share scheme)?
Capital Gains Tax (CGT)
- Share Incentive Plans (SIPS). If an employee holds shares under a SIP, they will pay CGT on any gain they have made from the time the shares were transferred to them to the date of the sale, unless the shares remain held in the SIP until just before completion.
- Save As You Earn (SAYE). If employees have bought shares under a SAYE scheme, they will pay CGT on any gain.
- Company Share Option Schemes (CSOPs). While any gain will be taxable as with a SIP or SAYE plan, since the option will generally vest at the time of completion if the company is sold, the shares will vest at market value so there will be no gain on which CGT will be chargeable.
- Enterprise Management Schemes (EMI). CGT will be payable on any gain made between exercise of the option and sale, but entrepreneur relief may apply.
- Non tax-advantaged schemes. CGT is payable on any gain.
Income tax and National Insurance contributions
- CSOP, SAYE. If a company changes control as part of a general offer for shares or a court sanctioned scheme of arrangement, income tax and NICs may become payable.
- EMIs. If an option to buy shares is given at market price, there will normally be no income tax or NI payable provided the option is exercised within 90 days of the sale. If the option is issued at a discount, income tax and NICs will be payable on the difference between option price and market price.
- Non tax-advantaged schemes. Income tax and NICs will be payable on the difference between the option and the market price (that offered by the buyer for the shares).
