Enterprise Management Incentive (EMI)

The Enterprise Management Incentive (EMI) scheme is a tax-advantaged share option scheme set up by the government with the core aim of assisting small and medium-sized enterprises in the recruitment and retention of key employees.

The scheme stands head and shoulders above the rest in terms of cost and flexibility for employers and tax advantages for employees. Our share incentives team offer fixed fee scheme planning, share valuation and implementation of EMI options for your business.

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EMI schemes offer companies the ability to reward their employees and incentivise and motivate them by granting them a stake in the business. The reason EMI schemes are such an attractive prospect is that compared with other available share schemes for UK-based businesses, they are the most tax-efficient option for both the businesses and their employees. 

For the employee, the main benefit is that neither income tax (nor national insurance contributions) is payable on the gain they realise on exercise of their options, or sale of their shares (provided that the exercise price is at least equal to the market value of the shares at the time the option is granted).

For the business, there will be no employers national insurance contributions to meet and a corporation tax deduction should also be available equivalent to the employees’ gain when the options are exercised.

In order for a company to qualify to grant EMI options, it must: 

(a)        be independent (and therefore cannot be the subsidiary of, or otherwise under the control of, any another company). In the case of a group of companies, it will be the parent company who grants the share options; 

(b)        have effective control of all of its subsidiaries (i.e. it holds more than 50% of their share capital).

(c)        be a trading company or the parent of a trading group, with a qualifying trade (most business activities qualify, but there are a number which don’t including  banking, farming and property development);

(d)        have gross assets of no more than £30 million at the time of grant and have fewer than the equivalent of 250 full-time employees; and

(e)        have, or its qualifying subsidiary must have, a UK permanent establishment.

A business may grant EMI options to any employees who work for the business for at least 25 hours a week, or if less than that, 75% of their total working time. They can only be granted to employees and not to non-executive directors or consultants.

Options can be granted up to a maximum value of £250k (valued at grant)  per employee.  A company can grant EMI options over a maximum of £3m value of shares (at grant).

Employees are not eligible for EMI options once they, or their associates (relatives, business partners etc) have a “material interest” in the company. A material interest will mean beneficial ownership of, control over, or right to acquire more than 30% of the share capital of the company.

Share options typically provide that the employee has to pay something to exercise the option and acquire the shares.   This is known as the ‘exercise price’ or ‘strike price’

The EMI rules provide that if the exercise price is at least the market value of the shares at the time of the grant of the option, then no income tax or NICs will arise on exercise of the options. Tax will then only be payable by the employee on a sale of the shares, at which time the whole of the employee’s gain (the difference between the option price and the sale price) will be taxed to capital gains tax (CGT).  If the options have been held for less than 2 years, the relevant rate of CGT is 20%. If they have been held for 2 years, then Entrepreneurs’ Relief may reduce the tax rate on the gain to 10%.

Giving your key employees a stake in the business which may lead to a cash realisation at only 10% tax rates, is a therefore a significant incentive  – encouraging high performance, and retention of staff.

If you would prefer the option price to be less than the market value of the shares, the option can still be a qualifying EMI option, but the difference between the exercise price and the market value of the shares at the date of grant will be taxed as if it were employment income.

This is illustrated in the following table.

In each case the share value must be assessed at the date at which you grant the options.  Historic information will be taken into account, as well, in certain circumstances as future events (such as a likely sale).

Share valuation is said to be an art, not a science, especially for a private companies where there is no trading platform for the shares.  Different valuation methodologies may be appropriate for different companies depending on the type of business.   However,  there are a number of valuation methods which are fairly standard and therefore usually acceptable to HMRC.  

For a start-up with no or minimal trading history, you are unlikely to need much in the way of a valuation, HMRC will usually accept that the exercise price is the nominal value of the shares.

For an active trading company a value might be arrived at through looking at some or all of the following factors:

  • Earnings per share
  • Dividend yield (and whether dividends are maintainable)
  • Price-earnings ratio (usually derived from comparables in the listed market and then discounted to reflect the lack of market)

Once a value for the whole company is established,  the value might further be discounted to reflect the minority shareholding being acquired and any restrictions that apply to the shares.  A 5% share in the company, for example would normally have no minority rights and therefore no way to force a distribution from the company, or influence its direction.   Were a hypothetical third party to buy those shares, they would not pay 5% of the equity value.

Typically, taking into account discounts for lack of marketability, minority interests and restrictions, a discount of 70-80% of what might be a ‘sale price’ of the whole company is usually applied to the option shares.

It is not a requirement of the scheme to agree the value with HMRC, but we do generally recommend it for all but the lowest value (start-up) companies.  An agreed value gives the company and the employees comfort that any valuation methodology used by the company is valid, that the exercise price is market value and that there will be no PAYE taxes due on exercise.  It also confirms that any options granted fall within the thresholds applying to the EMI scheme (such as £250k  of EMI options for individuals and £3m for the company). 

Valuations are dealt with by the Small Companies Enterprise Centre and HMRC aims to deal with applications wherever possible within 4 weeks of receipt. 

Again, it is not required.  However, in most cases we do recommend a professional valuation to ensure all the correct information has been taken into account and that the valuation methodology is appropriate.  In our experience, after engaging a valuer and applying the various factors  and discounts described above, companies are able to offer options at a lower exercise price than originally envisaged – thus giving employees an additional benefit. 

In addition, on a future sale of the company (which may trigger exercise of the EMI options) the existence of a thorough third party valuation which has been agreed by HMRC should mean that any buyer is comfortable that no PAYE taxes will arise in respect of the sale, even where significant gains have been made in a relatively shortly period.   

If you do decide a professional valuation would be useful, your accountants or auditors may provide one.  We also offer, as part of our ‘EMI package’,  a cost effective valuation from a specialist valuer.

Ascertaining the value of the company’s shares is key in making your EMI Scheme effective and a real incentive for your employees.  Please contact Craig Bowers or Elizabeth Middleton for further information.

Clients usually think that if they are planning a sale of the company then it is too late to implement an EMI Scheme. This is not necessarily true.

From our guidance on valuation it can been seen that under established valuation principles, where no sale is in view, a significant discount is applied to the pro-rated share value (and therefore the exercise price)  to reflect the lack of market for the shares.   This because in assessing the market value of specific shares for tax purposes, it is necessary to consider what a hypothetical buyer would pay for the shares.  The price payable would reflect the lack of marketability of the shares.

If a company is preparing for sale, it follows that there is a potential market for the shares, and it could be argued that the market value on options delivered before the sale is the likely value on realisation (thus delivering no benefit to the employee).

However, the position is not so straight forward.   A sale may be contemplated, but sellers may not get an offer they are satisfied with; the sale might stall during the early stages, or during due diligence by the buyer; and it is not uncommon for sales to abort all together. In assessing the market value, therefore, the hypothetical buyer would discount from any anticipated sale price an amount that takes into account the risk that a sale might not proceed and that the sale price is uncertain

At the very early stages of a sale (such as engaging a corporate finance team), it is arguable that the risk is significant and therefore that the 70/80% discount should not be much reduced.

As a sale proceeds, then depending on the specific facts, the discount might reduce, but even then, one would not expect there to be no risk (and therefore no discount) until immediately before the contract is signed and there is certainty of realisation at a fixed price.

In practice we have seen HMRC agree reasonable discounts even where a sale is imminent.  In one case HMRC agreed a 30% discount to pro-rated value.

If employees are offered EMI options with any discount during the initial stages of a sale, then they stand to benefit if the sale is achieved. Effectively the difference between the discounted exercise price and the price per share achieved on completion will be taxed at CGT rates rather than income tax rates.   A tax efficient ‘success bonus’ may therefore be delivered to key employees.

Our EMI scheme offering

Why us?

The EMI scheme is the gold standard of share incentive schemes.  For companies that qualify, it provides flexible and tax efficient equity participation for employees and is a valuable incentive and retention tool.

Despite its flexibility, it is important to note that the legislative criteria for qualification are strict, and in some aspects, complex.  

As experienced corporate transaction lawyers we have seen examples of EMI option agreements which have been poorly drafted and which, as a result, do not qualify. We have also seen examples of schemes being put in place where the company does not qualify to grant EMI options.  Often, a problem emerges when the company is being sold and tax advisors or accountants carrying out the buyer’s due diligence spot errors.   Unfortunately this often results in options which were thought to be qualifying, instead being taxed as ‘unapproved options’.   The difference in tax rates between 10% and 47% (including NICs) of the employees’ gain, is very bad news, and often the majority shareholders or company feels obliged to make up the difference to employees with a significant impact on sale proceeds.

In addition to drafting the scheme rules and ancillary documents we can advise you on any changes to your articles to create new employee shares (if required) including provisions to ensure the employee shares are acquired back by the company from leavers.

 

Our share valuation service

Agreeing the value of your shares at the date the option is granted is key to both to ensuring that the options are within the limits of the scheme and deliver value to employees.

We have teamed up with corporate finance and valuation firm, Aurora M&A Solutions Ltd, and are now able to offer a valuation within our fixed fee EMI scheme pricing.  This means that we can do all the work in relation to your EMI Scheme as a ‘one stop shop’.

If you would like further information or a quote for your EMI Scheme, please contact Craig Bowers or Elizabeth Middleton.

 

What if the company is not eligible for EMI options?

If your company or employees do not meet the criteria for EMI options we can advise you on other tax-effective share schemes to enable employees to participate in the company.

Typically these schemes involve the employee acquiring the shares (rather than options)  upfront at a low value, so there is no income tax charge on issue. Having paid full value, the employee is only liable for CGT on future growth in value.

The following is a general description of some of the possibilities:-

 

‘Reverse Share Option Scheme’

If the shares are currently of low value, for example if the business recently started trading, or there are significant intra-company loans, then from a tax perspective it can be advantageous to simply issue the shares upfront at par value. 

The shares could then be forfeited if performance targets are not met.  This is sometimes called a ‘reverse option scheme’ as it has a similar economic effect to a traditional option.  Shares can be drafted to have no voting or dividend rights if the intention is only to give value on an exit.

 

 

Nil or Partly Paid Share Scheme

If the market value of the shares is too high for the employees to contemplate buying them, a nil or partly paid share scheme might provide a solution.  In such a scheme, the employee is committed to paying the full value of the shares, so no income tax charge arises on grant, but the payment is deferred until the company calls for it on a sale of the business.

 

Growth Shares

A growth share scheme involves the creation of a new class of shares which only participate in profits above a hurdle value.  The value of such shares on issue is arguably negligible as they only have ‘hope value’ of future participation.

 

Joint Share Ownership Plan (‘JSOP’)

In a JSOP the employee shares ownership of the relevant shares with an employee trust.  Under arrangements with the trustees the equitable interest in the share changes over time so that the employee gets the benefit of value over a certain threshold.  Again the rationale is that the value at the date of grant is low, so there is no income taxable benefit. 

The starting point for designing all tax-effective share schemes is an assessment of the current value of the shares for tax purposes.  We have partnered with corporate finance and valuation firm Aurora M&A Solutions Limited to provide competitively priced valuations so can assist in providing a valuation where that would be helpful.

Our share schemes team specialises in bespoke share scheme design and implementation for SMEs.  If you would like further information or to discuss your share incentive please contact  Elizabeth Middleton or Craig Bowers

If you would like to discuss how you might utilise an EMI or other share incentive scheme for your business, please do get in touch with one of the team.