Growth Shares in the UK

Once a company has raised a priced funding round, its ordinary shares carry a meaningful market value. Giving a new senior hire ordinary shares at that point, or an option exercisable at a low strike, either creates a large income tax charge or fails EMI limits. Growth shares solve this by creating a new class of shares that only has value above a hurdle set at or near the current valuation, so the shares are worth very little on day one, which keeps the equity tax charge small at issue.

• The hurdle is usually set at or slightly above the last funding round valuation
• The recipient only benefits from growth in company value above the hurdle
• Because the shares are worth little at issue, the acquisition cost or tax charge is small
• Growth shares are real shares, so subsequent gains are normally taxed as capital gains, not income

Suppose a company is valued at 20 million pounds after its last round. A new hire is issued growth shares with a hurdle of 20 million pounds, meaning the shares only carry value once the company is worth more than that. An independent valuation might value these growth shares at 5,000 pounds in total given how far away the hurdle is and how likely it is to be cleared. The employee pays 5,000 pounds for the shares, a small but real cost, rather than paying nothing and facing an income tax charge on a much higher value, unlike the tax treatment on share options with a strike set below market value.

If the company is later sold for 60 million pounds, the growth shares participate only in the 40 million pounds of value created above the hurdle, according to the percentage allocated to that class. The employee's gain from the 5,000 pound cost to the eventual sale proceeds is generally a capital gain, not income, the same treatment that applies to most other shares held by employees.

Growth shares need an independent valuation at issue, since their value depends on modelling the probability and scale of value growth above the hurdle, not simply a proportion of current company value. This is usually done using an option pricing style model that considers time to a likely exit, volatility and the size of the hurdle relative to current value.

Because this valuation is judgement based, companies typically instruct a specialist valuation firm and keep the valuation report on file in case HMRC queries the acquisition price later.

Growth shares are usually restricted securities, meaning they carry conditions such as good leaver or bad leaver provisions that could reduce their value. Restricted shares are normally taxed on their restricted value at acquisition and then face an income tax charge later when restrictions lift or the shares are sold, based on the unrestricted value at that point.

A joint Section 431 election, signed by the employee and the company within 14 days of the shares being acquired, elects to be taxed upfront on the unrestricted market value instead. Because growth shares are usually cheap at issue thanks to the hurdle, paying tax on the unrestricted value at that early point is normally far cheaper than facing an income tax charge on a much larger value later. Missing the 14 day deadline is a common and costly mistake.

The Section 431 election is irreversible and must be filed within 14 days of acquisition. There is no extension. Companies issuing growth shares should prepare the election alongside the share purchase agreement so it can be signed immediately.