64 deals £1.780 Billion

PEARLS OF WISDOM

INVESTOR PROTECTIONS

Private equity investors are normally supportive of well structured share option incentives for management, but they will  wish to protect their investment by:

• limiting the ‘pool' of shares available for options to  prevent excessive dilution

• linking the exercise of options to an 'Exit Event' such as a sale or listing of the company, so as to align the investor's interest with that of management

• not allowing the exercise price of the options to be set at below the market value of the shares at the date of grant

• ensuring that any employer's national insurance contributions that arise on the exercise of option can be recovered from the option holders to prevent this cost impacting on the company's profit and loss account

COMMON SCHEMES

The most common schemes are an:

• Enterprise Management Incentive ('EMI') Share Option Scheme; and an

• Unapproved Share Option Scheme ('Unapproved Scheme').

EMI

EMI is an extremely tax advantageous share incentive scheme. An EMI option offers the following tax advantages:

• on grant of the option - no income tax or national insurance contributions arising

• on exercise of the option - no income tax or national insurance contributions arise (provided that the option is granted with an exercise price set as the market value of the shares at the time of grant)

• taper relief for capital gains tax purposes will start to run from the date of grant of the option (rather than from the date of acquisition of the shares themselves).

From the manager's perspective, an EMI option therefore affords him the opportunity to acquire shares without any employment taxes and provided that the manager has held his option/shares for at least 2 years before an exit, the rate of capital gains tax payable should taper down from 40% to 10% (in the case of a higher rate tax payer).

EMI CONDITIONS

Under an EMI, share options can only be granted to qualifying employees (generally those full time employed without an existing significant interest in the shares).

There are a number of conditions to be satisfied for these tax advantages to be obtained. Primarily:

• the company should not be under the control of another company

• the gross assets of the group must not exceed £30 million

• at least one group company must exist for the purpose of carrying on a qualifying trade and must carry on that trade

• the trade must be carried on wholly or mainly in the UK and must not carry  on excluded activities such as dealing in land, dealing in goods (other than as wholesale or resale distribution), property development, providing legal or accountancy services, farming or market gardening; operating or managing hotels or similar establishments, operating or managing nursing homes or residential care homes, banking, insurance, debt factoring or holding, occupying or managing woodlands.

EMI options are subject to two important limitations:

1. the total value of shares, in respect of which unexercised EMI options exist, cannot exceed £3 million

2. a manager cannot hold unexercised EMI options in respect of shares with a total value of more than £100,000.

For both of these limits, the value of the shares under option is taken as their market value (ignoring any restrictions attaching to the shares) at the date of grant.

UNAPPROVED SCHEME

Sometimes the company or the managers will not qualify for EMI options and in these circumstances an Unapproved Scheme is usually implemented.

Although the Unapproved Scheme affords a great deal of flexibility as it does not have to comply with any statutory rules, the tax benefits associated with an EMI option listed above are not available for options granted under an Unapproved Scheme.

On the exercise of an unapproved option, both income tax and employee's and employer's national insurance liabilities will arise on the amount of the option gain and taper relief will not start to run until the exercise of the option occurs as opposed to its grant.

ARTICLES OF ASSOCIATION

The articles of association of the investee company need to be drafted so as to facilitate the proposed share scheme. It is important to ensure that:

• any pre-emption rights on issue appearing in the articles will not apply to the issue of shares to satisfy the exercise of options under the proposed scheme

• any pre-emption rights on transfer appearing in the articles will not apply to the transfer of shares to satisfy the exercise of options under the proposed scheme

• there are no prohibitions against the adoption of a share scheme or the issue of shares or the transfer of shares pursuant to options granted under such scheme in the investment agreement.