Growth shares: What are they and when to choose them over share options

You’ve heard of ordinary shares and preference shares – but what are growth shares? You might have heard that growth shares are an alternative to share options.

In this article, we explain what growth shares are, how they work, and when it’s better to issue growth shares instead of share options.

What are growth shares?

Growth shares are a special class of shares that have a hurdle. Growth shares only have a value if the company’s share price is above the hurdle.

This means when you give someone growth shares, and you choose a hurdle that matches the company valuation today, the growth shares have zero value when they’re issued. They only have a value if the share price goes up – we’ll explain below the advantages and disadvantages of that.

You might also see growth shares called ‘hurdle shares’ or ‘flowering shares’. And in the USA, growth shares are called growth stocks.

How do growth shares work?

Growth shares are issued at a ‘hurdle’. The hurdle is the amount the share price must be over for the shareholder to benefit when they sell those shares.

Example

🚧 You issue growth shares to Alex at a hurdle of £1 per share.
📈 Three years later, you sell the company, at a valuation of £10 per share.
💰 Each shareholder who has ordinary shares gets a payout of £10 per share.
9️⃣ But because Alex’s growth shares have a hurdle of £1, he only gets £9 per share.
📉 If you sell the company for less than £1 per share, Alex gets nothing.

Why issue growth shares?

The #1 use for growth shares is to give shares to late-joining founders and key employees who don’t qualify for EMI options without the tax liabilities that normally come with giving ‘free’ shares. (An employee might not qualify for EMI options because either they or the company would be over the EMI scheme limit of 250 people.)

Example

🍾 Startup Xampl has recently closed its Series A round, at a price of £10 per share.
🤝 Xampl plans to hire a new CEO and to give her 10,000 shares, vesting over 3 years.
🎫 Xampl doesn’t qualify for EMI and the new CEO wants voting shares not share options, so they agree to issue shares.
💰 If Xampl give the CEO ordinary shares, those shares would have a value of £100,000. This would mean the CEO, because she’s an employee of the company, might incur an income tax charge as if she’d been paid £100,000 in cash. And Xampl would need to pay PAYE and National Insurance as if it had paid the CEO £100,000 as part of her salary.
😱 The CEO gets a big unwelcome surprise when her accountant informs her that she has a £40,000 tax liability for the £100,000 worth of shares – which she can’t sell anytime soon.

So, is there a way to avoid the tax issues?
Yes: growth shares.

The solution for our example is that the company issues the CEO with growth shares with a hurdle of £10 per share. Normally, you pick a hurdle that’s a bit higher than the last round price per share to be certain there won’t be any tax issues, but here we’ll go with £10 per share.

This means that the shares have zero value today so Xampl can issue the growth shares to their new CEO without tax liabilities for either party.

The downside is that the growth shares only have a value if the share price goes up. But this is an incentive for the new CEO – until she’s helped the company increase the share price, her shares are worth nothing.

What are the other advantages of growth shares?

• You minimise dilution for existing shareholders
  Usually when you issue new shares, your existing shareholders are diluted: the percentage of the company that they own decreases. But with growth shares, your existing shareholders are only diluted when the value of the company grows past the hurdle.
• Growth shares can be an incentive to hire and retain staff
  You can offer growth shares alongside salary to reward your team, without the tax issues that come with giving free shares. (Bear in mind that in many cases, EMI share options are a better choice.)
• Growth shares can incentivise hard work and commitment
  Because growth shareholders benefit only if the company has grown when it’s sold, these shares work as an incentive to work hard to help grow the company.
• You can issue as many growth shares as you like
  Unlike EMI share options which are limited to companies of 250 people or fewer and various other restrictions, there’s no HMRC restriction on which companies can issue growth shares.
• You can give growth shares to whoever you want
  Unlike EMI options which are for employees only, companies can issue growth shares to employees, contractors, freelancers or advisors.
• There’s no time limit on growth shares
  EMI share options must be exercised within 10 years of being granted – but growth shares have no time limit: the shareholder owns them until they’re sold.
• Growth shares can be voting or non-voting
  It’s up to the company to decide. Usually recipients of growth shares don’t get dividend rights, and might or might not get voting rights.
• You can set conditions
  When you issue growth shares, they can be conditional. For example, on the shareholder staying with the company for a set amount of time, for hitting their targets, or on company milestones. To set conditions for growth shares, this ability must be set out in your Articles of Association.
• Growth shares can impress investors
  If you’ve issued growth shares, this sends a strong message to prospective investors that your company is committed to growing. This makes your business look like a good bet for the investor to get a good return on their investment.

What are the disadvantages of growth shares?

• Growth shares have no value when issued
  If the share price doesn’t go up, or the growth shareholder sells the shares before the price goes up, they get nothing. As opposed to if they had owned ordinary shares – then they’d get back whatever the price per share was when they sold the shares.
• The shareholder might be liable for CGT
  When growth shares are sold, any profit counts as a ‘gain’ and the shareholder might have to pay Capital Gains Tax. CGT liability depends on their individual circumstances.
• If you issue the shares with too low a hurdle, the shareholder pays Income Tax
  To avoid paying Income Tax, the growth shares need to have a hurdle that’s at least as high as the price per share determined by an independent expert on valuing the company (see next point).
• You need to get your company valued – every time you issue growth shares
  To issue growth shares, you’ll need to pay a qualified person or firm to produce an accurate valuation for your company. The valuation sets the market value of your shares now, to help you decide on the hurdle rate for the growth shares. You’ll need to keep accurate records of the valuation in case HMRC challenges it later.
• HMRC could decide your valuation was too low
  Even if you get a proper valuation by someone suitably qualified, HMRC could decide the valuation was too low. If that happens, your growth shareholders might be liable to pay more tax on their ‘income’ and/or ‘capital gain’ from these shares.
• Growth share schemes can be complicated and expensive to set up
  Because it involves getting a valuation, making complicated decisions (what happens if a growth shareholder leaves? etc) and updating your company documents, it can take weeks (or months) to set up a growth share scheme and cost a fortune in legal fees. Many companies find it’s much easier to set up an EMI share option scheme instead.

What are the tax implications when you issue growth shares?

When you issue growth shares, because they have no value at that point, the recipient isn’t liable to pay Income Tax on those shares. And there’s no National Insurance contribution for you to pay.

When your shareholders sell their shares, they might be liable to pay Capital Gains Tax – this depends on their personal circumstances. There are full details about CGT on the sale of shares at the gov.uk website.

Sales of growth shares aren’t usually eligible for Business Asset Disposal Relief (formerly Entrepreneurs’ Relief) – to see why, take a look at the rules on the gov.uk website.

Bear in mind that HMRC can change how share issues and gains are taxed – you should brief recipients of growth shares that the tax treatment might change in future.

If the recipient of the growth shares isn’t a tax resident in the UK, the tax implications for them depend on the rules in the region where they pay tax.

I have an EMI option scheme, can I issue growth shares as well?

You can issue growth shares as an alternative to EMI options, or you can run an EMI option scheme and issue growth shares too. You can even set up an EMI scheme and an unapproved scheme and issue growth shares.

EMI options vs growth shares: what’s the difference?

Here’s how an EMI option scheme stacks up against growth shares:

How to set up a growth shares scheme

To issue growth shares, here are the steps you’ll need to take:

• Amend the Articles ✍️
  You’ll need to update your company’s Articles of Association to create the new class of shares: growth shares.
• Get shareholder agreement 🤝
  You need permission from existing shareholders to amend the company’s Articles
• Create your growth shares scheme 🪄
  Draft and agree the rules for how you’ll issue growth shares, such as the hurdle rate and conditions on the share award.
• Get a company valuation 🧮
  Engage a qualified person or firm to value your company. The valuation determines the current market value of your shares now. Keep accurate records of the valuation in case HMRC requests this information in future.
• Sign a growth share agreement 🖊️
  The company signs this agreement with the recipient of the growth shares.
• Issue the growth shares 📄
  The final step: allocate the shares to your team member. They become a named shareholder straight away.

Can I create growth shares on SeedLegals?

Yes – you can create growth shares on SeedLegals.

If you’re doing a funding round, here’s how it works:

• log into SeedLegals, go to Raise and select your funding round
• in Advanced Terms, choose growth shares
• select the share class and set the hurdle

We automatically update the corresponding wording in your Articles of Association.

If you aren’t planning to do a funding round, we can help via our General Counsel as a Service. To find out more, book a free call.

Talk to an expert

Interested in offering growth shares? Book a free call with our experts to talk through how it works. (If you’re considering giving equity to your team as share options, take a look at our page about option schemes.)