“It has been a couple of years since I made a promise to give this person (who is now the biggest biller) shares in the company, so can you please draw up the documents to put this in place.”
This is the start of so many conversations we have with our recruitment agency clients. Each situation is unique and whether the offer of shares in the company was the luring factor that brought an employee to the business is debatable. That said, the point remains that many recruitment businesses make this share offer without fully appreciating the commercial, financial and tax implications.
Shareholders of recruitment agencies thinking about parting with a share of their business need to consider the following:
(i) are you comfortable with the dilution effect (share of voting rights, payment of dividends and sale proceeds from the sale of the company);
(ii) what is the issue price of the shares?
(iii) what happens to those issued shares when the employee leaves the company?
The “Dilution effect”
In order to address this issue and find the most suitable solution (of which there are many), recruitment agencies need to think about what the employee is expecting to receive from these shares. Many recruitment agencies prefer to issue share options that only turn into shares on the date of a sale of the company. This deals with the dividend and voting dilution effect. However if the employee is expecting to be paid dividends and have a vote at shareholder level then granting them “exit only” share options will not work. Is the employee expecting to take an immediate share in the value of the business as at the date he/she joined or is that person only expecting to share in the value added post them joining?
Share Issue Price
The issue of shares to an employee at below market value will be seen as a benefit in kind by HMRC. Therefore knowing what the market value is of these shares is critical to understanding any tax implications for the business issuing the shares and for the employee receiving those shares. Recruitment agencies can agree that market value with HMRC prior to the issuance of those shares is either by issuing them under the Enterprise Management Incentives (EMI) scheme or under the Employee Shareholder Share (ESS) scheme. Both these schemes contain a number of qualifying conditions and recruitment agencies would need to satisfy themselves (with advisor input) that these conditions have been met. By pre agreeing the market value price of the shares with HMRC a recruitment agency has certainty of the tax implications for all concerned and ensures that there is not a latent tax liability sitting within the business. Unknown tax liability issues will be seen as “red flag” issues for any potential buyer or investor and their response can range from walking away from a deal or asking for money to be placed in escrow for a period of time.
What happens to issued Shares when the Employee Leaves the company?
When issuing the shares the current shareholders need to decide whether they or the business intend to take back the shares when an employee leaves the business. In the majority of the cases shareholders will want to have that ability, as they will not want value going to somebody outside of the business. Furthermore unless they take back these shares they will need to dilute themselves again to issue any further shares to his/her replacement. The question is then, what value should that ex-employee get for those returned shares? There are various options available here ranging from the employee getting back the money he paid in all departure circumstances to the employee getting a % of his shares repaid at market value based on time spent in the business.
Why is it important?
Even if a recruitment agency has not promised a share of the business to an employee then they should be taking it into consideration. By putting these structures in place shareholders of recruitment agencies are giving themselves the best chance of an exit. Potential acquirers and investors will be attracted by the fact that beyond the core shareholders there is a management team that also takes a share in the fortunes of the business.
If you want to speak more about employee share issues then please contact EMW’s Head of the Recruitment Sector team- Gurpreet Sanghera 0345 074 2356 firstname.lastname@example.org.