How can you align employee incentives with your startup's long-term success? It may be time to consider growth shares. Growth shares are a type of equity award that can help align the interests of employees with those of shareholders, incentivizing them to work towards the long-term growth of the company. But what exactly are growth shares, and how do they work?
In this article, we will explore the definition and significance of growth shares, how they work, their taxation implications, and the benefits they offer to both employees and employers.
Growth shares are a type of equity award that allows employees to participate in the growth of a company over a specified hurdle or threshold. They are a special class of shares that are usually issued by unlisted companies to provide equity incentives to management and key employees. Growth shares reward participants for the growth in value of the company above a "threshold" or "hurdle" which is specified on issue.
At the time of issuance, growth shares have little or no inherent value, as their worth is contingent upon the company achieving significant growth and surpassing the set hurdle valuation. This hurdle value is typically established above the company's current market value, creating a target that the company must reach before the growth shares become valuable.
The primary purpose of growth shares is to align the interests of employees with the company's growth objectives. By tying the potential value of these shares to the company's ability to increase its valuation beyond the hurdle, growth shares incentivize employees to contribute to the company's success and growth over time.
Moreover, growth shares offer a tax-efficient way to compensate employees. Unlike traditional stock options, where gains are often taxed as ordinary income, the appreciation in value of growth shares is typically subject to capital gains tax rates when the shares are eventually sold or disposed of, providing a potential tax advantage for participants.
Growth Shares give employees a special class of shares with attached economic rights, which are only applicable once the value of the company crosses the threshold set- usually known as “valuation hurdle”. The hurdle rate is usually above the current market value of the company.
Once a trigger event does occur and the company’s value exceeds the hurdle, the shares accumulate value depending on the company’s following growth rate. This allows employees’ growth shares gain value if the company continues to grow.
The value of growth shares is calculated by subtracting the initial valuation from the current value of the company. For example, if a company is valued at $10 million at the time of the grant and $15 million at the time of exercise, the growth share holder would realize a profit of $5 million.
The tax treatment of growth shares is generally more favorable than that of ordinary shares or share options, as gains are taxed as capital rather than income. This is because growth shares are typically issued at a discounted price, with the potential for significant upside if the company performs well. The value of growth shares is linked to the future growth of the company, rather than its current value.
When growth shares are issued, they are typically valued at a price that is below their market value, often at a discount of 10-40%. This means that the initial investment required to acquire growth shares is lower than the cost of acquiring ordinary shares. When the company is sold, the growth in value of the growth shares above the hurdle rate is subject to capital gains tax, which is typically lower than income tax rates.
In summary, growth shares offer a tax-efficient way for employees to participate in the growth of a company, as gains are taxed as capital rather than income. However, it is important to ensure that the growth shares are valued correctly and that any discounts are considered when calculating the tax liability.
Issuing growth shares involves several key steps to ensure a smooth and effective process. Firstly, the company needs to determine the valuation of the business, considering factors such as current market value, growth potential, and any existing agreements or restrictions.
Next, a growth share plan must be established, outlining the terms and conditions of the equity awards, including the hurdle rate and any performance criteria. This plan should be approved by shareholders and comply with legal and regulatory requirements.
Once the plan is in place, the company can issue growth shares to selected employees, consultants, or directors at the agreed-upon valuation. It is essential to communicate clearly with recipients about the terms of the growth share issuance, including any vesting schedules or conditions for realizing gains.
Regular monitoring and review of the growth share scheme can help ensure its effectiveness in incentivizing and rewarding key contributors to the company's growth.
The following are the benefits of growth shares:
1. Tax Efficiency: Growth shares allow gains to be taxed as capital in the hands of participants, offering a tax-efficient alternative to options.
2. Alignment of Interests: Growth shares incentivize employees to work towards the long-term growth of the company, aligning their interests with those of existing shareholders.
3. Preservation of Current Value: Growth shares help preserve the current value for existing shareholders, ensuring that this current value is not diluted.
4. Retention and motivation: The potential for significant financial rewards can help retain key employees and motivate them to drive the company's growth.
5. Liquidity and exit opportunities: Growth shares can provide employees with liquidity and exit opportunities, allowing them to realize the value of their shares upon a successful exit event, such as an acquisition or initial public offering (IPO).
The main difference lies in the fact that ordinary shares provide ownership stake to any investor in the market, while growth shares are particularly issued to incentivize and reward employees.
Growth shares do have a little more risk attached to them, as their valuation is dependent on future growth of the company, contingent on the company passing the hurdle rate. However, growth shares provide holders with more economic rights attached.
Overall, growth shares might be a great approach to take for firms looking to provide employees with incentives for their performance, and to motivate them towards your long-term goals and growth.
Growth shares and share options both have their advantages and disadvantages. Growth shares may be more tax-efficient for employees, as they are typically subject to capital gains tax rather than income tax. However, share options may provide more flexibility in terms of exercise timing and potential upside. The choice between the two depends on the specific circumstances and objectives of the company and its employees.
To set up a growth share scheme, companies typically use a growth share plan, which sets out the terms and conditions of the equity awards. The plan must be approved by shareholders and must comply with all relevant legal and regulatory requirements.
Growth shares can be used by any company that is looking to incentivize and reward its employees for their contributions to the long-term growth of the company. They are most used by startups and growth-stage companies, which are typically more focused on long-term growth than short-term profits.
For employers, growth shares can be a powerful tool for attracting and retaining top talent. By offering employees a stake in the company's success, employers can create a sense of loyalty and motivation among their workforces.
There lies a fundamental difference between them as growth shares provide direct ownership stake in the company while options provide holders with the right to buy shares for a certain price at a certain time. Options work if vesting conditions are met, while growth shares work if the hurdle threshold is crossed.
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