Why tax valuation is key in designing equity-based employee incentive plans for private companies

Given the ever-changing and challenging environment facing businesses today, it is important to limit risk where possible. For example, over the past two years, COVID-19 has caused dramatic fluctuations in the value of some businesses. The pandemic initially gave rise to some significant declines in value but two years and many vaccines later, many businesses have regained the confidence of the markets—only to be hampered by new uncertainties arising from the war in Ukraine. Businesses find it more important and challenging than ever to ensure that they have the right people in the right place at the right time. One key part of an employee package, which can make the package more attractive to potential recruits, is a medium- to long-term equity plan. Small- and medium-sized enterprise (SME) employers are increasingly seeking to implement equity plans to ensure that they can retain and reward key staff, and compete with the packages offered by listed or multinational companies.

Why are tax share valuations important for management incentive plans?

First, assigning a value to the equity will demonstrate to the employee that they are receiving an incentive that has potential value. Second, a tax valuation will assist the employer in demonstrating that they have met the “best estimate” test, which is required by Revenue to determine the value of any benefit provided. If the employee pays less than market value, the company would be obliged to ensure that taxes are applied through the PAYE system.

Once the company’s value has been determined, a tax valuation can provide a business with an objective view of the current state of affairs and can be used as a benchmark for future growth and performance targets. It is vital to first understand the current status of the business before identifying future goals.

Shares given to employees may have differing rights. It may not simply be a case, therefore, of dividing the number of shares by the company value. If growth or hurdle shares are issued, it will be important to use a forward-looking technique such as option pricing or the Probability Weighted Expected Returns Method (PWERM).

Where an equity incentive is provided, it should generally be possible to achieve capital gains tax rates at 33% on an exit as opposed to income tax, which can be as high as 52% on employment income.

What impacts the tax value of shares?

A number of factors could influence the tax valuation of shares. As mentioned above, it may not be as simple as dividing the company value by the number of shares. It also may not be possible to obtain all the information considered necessary for a share valuation, but the following factors, among others, are often considered:

• The current valuation of the company

• Other recent share transactions within the business

• The specific rights of the shares issued to employees

• The shareholder profile of the business

• Future projections for the business and the likelihood of these being achieved

• Prospects for the industry, including external and internal factors

• Prospects for the business

• The cash flow of the business

• The amount of liabilities

• The effect of inflation

• Timeframe for a potential exit

Discounts can play an important role and may have a significant impact on the tax valuation when offering equity to employees, as the value of one share can be discounted to reflect a lack of control or lack of marketability. Typically, small minority shareholders have an uninfluential interest in the business and shares offered in SMEs are non-tradeable with no readily available market in which to dispose of the shares. It is widely accepted that a minority stake would be viewed as having a lower value per share due to the lack of control or influence. These discounts enable employees to purchase equity in the business at a current fair market value, often at a notably lower value than other significant shareholders. Many factors can contribute to the minority or marketability discount (this is not an exhaustive list, as additional factors may need to be considered):

• Other comparable transactions in the company
• Size of holding
• Level of influence (e.g. single digit)
• Voting entitlements
• Dividend entitlements
• Size of other shareholdings (e.g. small or large group of shareholders)
• Number of shareholders
• Likelihood of an exit
• Nature of the company’s activities
• Level of dividends being paid
• Terms of the shares

The three key actions to take now

1. Consider the current valuation of the business

Internal and external factors can affect the value of the business and it is necessary to establish the correct value as a starting point. If the value is high, it may limit your ability to issue ordinary equity with no restrictions to your key employees.

2. Consider what you want to achieve with the incentive plan

Reflect on how much value you would like to attribute to the incentive plan. Do you want to place a cap on the potential future value that is given to employees or directors? Tax valuations can be tailored to the specific requirements of a business.

3. Key employees and directors

Consider who you would like to offer the incentive to. Whether it is the next generation or key employees, it is important to have a clear picture of who you are looking to incentivise and tailor the plan accordingly.

We are here to help you

As equity participation continues to grow in importance, it is crucial to ensure that equity is considered as a key element of any package when recruiting, retaining and rewarding key employees. Our expert team has extensive experience in implementing equity incentive plans and undertaking the required tax valuations. We can guide you through the sometimes challenging process, which can prove pivotal to future business growth. Contact us for more information.