Growth Shares and Vesting Conditions: A Guide for Startups and Scaling Businesses

Callum Ritchie December 5, 2024

Growth Shares and Vesting Conditions

Growth shares have become an increasingly popular tool for incentivising employees and consultants, particularly in high-growth startups and scaling businesses. By aligning key personnel with the company’s long-term success, growth shares serve as an effective mechanism to attract, retain and motivate talent. This article delves into what growth shares are, how vesting conditions work and why companies might opt for them over alternatives like EMI share option schemes.

What are Growth Shares and Vesting Conditions?

Growth shares are a special class of shares that allow holders to benefit from the future growth of a company, without participating in the current value or assets of the business. Typically, these shares only deliver value if the company grows beyond a pre-agreed valuation threshold, known as a “hurdle rate.” This ensures that the benefit to the holder is tied directly to the company’s performance after the shares are issued.

For example, if a company’s current valuation is £5 million, growth shares might have a hurdle rate of £7 million. Only the value created above £7 million would benefit the growth shareholders.

Vesting conditions are performance or time-based requirements that must be met before the holder can benefit in any value above the relevant hurdle. These conditions are designed to ensure that the individual continues to contribute to the company over time or meets agreed performance targets.

Differences between Growth Shares and Options

Feature	Growth Shares	Share Options
Ownership	Immediate ownership upon allotment.	Ownership arises only upon exercise.
Cost	Often require a nominal subscription price.	Exercise price set at grant.
Company Growth	Linked to future company growth.	Based on the value of the shares on exercise.
Voting/Dividend Rights	Can carry voting/dividend rights.	None until option is exercised.

Growth shares are often preferred when the company wants to deliver immediate ownership tied to company performance, while share options are often simpler to administer and delay share ownership and taxation until exercise.

Unvested Growth Shares

Growth shares are typically allotted at the outset of the employee’s or consultant’s involvement, with vesting conditions outlined within the specific individual’s subscription agreement. Unvested growth shares often:

Restrict economic participation: Until vesting conditions are met, holders may not be entitled to dividends, voting rights or capital distributions.
Structured as Non-Participating: During the unvested period, they may be classified as non-participating shares to reflect their contingent nature.

Documents required to implement Growth Shares with Vesting Conditions

The implementation of growth shares involves several key documents:

Articles of Association: These must be amended to create the new class of growth shares and define their rights, including outlining when a growth share will be deemed non-participating and the mechanics of how the hurdle works.
Shareholders’ Agreement: This document would normally include additional restrictions attached to the shares as well as provisions outlining what happens where an employee or consultant departs the company.
Subscription Agreement: Documents the individual’s agreement to purchase the growth shares, the hurdle rate and any vesting conditions applicable to the shares.
Employment or Consultancy Agreement: The holding of the growth shares is usually linked to the continued employment of an employee or the continuous provision of services by a consultant.
Shareholder Resolutions: Resolutions will be required to adopt the new articles (among other things).
Valuation Report: Establishes the market value of the shares thereby providing the company with the information it needs before agreeing upon a hurdle rate.

Tax treatment of Growth Shares with Vesting Conditions

The tax treatment of growth shares can be complex and depends on the structure of the scheme:

On allotment: If growth shares are issued below market value, the difference may be subject to income tax.
Hurdle rate impact: A carefully structured hurdle rate can reduce the initial taxable value.
Capital Gains Tax (CGT): Once vested, any growth in value is typically taxed as a capital gain upon disposal.

Obtaining an HMRC valuation clearance in advance can mitigate disputes and unexpected tax liabilities.

Examples of Common Vesting Conditions

Time-based vesting: Shares vest over a specified period (e.g., 25% per year over four years).
Performance-based vesting: Tied to individual or company performance metrics, such as revenue targets or EBITDA thresholds.
Exit-linked vesting: Shares vest only on a liquidity event, such as a sale or IPO.
Hybrid conditions: A combination of time and performance-based criteria.

Advantages and Disadvantages of Growth Share Schemes

Advantages:

Alignment with company success: Directly ties rewards to growth and profitability.
Lower initial cost: Employees may pay nominal amounts to acquire shares.
Tax efficiency: Capital gains tax on disposal can be more favourable than income tax.
Retention tool: Vesting conditions incentivise long-term commitment.

Disadvantages:

Complexity: Requires legal and tax advice to implement.
Tax risks: Potential income tax charge on undervalued shares.
Incompatible with SEIS and EIS: It may be incompatible with the company’s fundraising plans, especially where the company is looking to raise funds pursuant to SEIS and EIS (note it is possible to have a growth share scheme alongside raising SEIS and EIS funds, although it is rare for companies to do so given that SEIS and EIS shareholders are not able to have a preferential right over other share classes).

Why choose Growth Shares over EMI Schemes?

While EMI (Enterprise Management Incentive) schemes are tax-advantaged and straightforward, they may not be suitable for every company:

Eligibility: EMI schemes are restricted to smaller, independent companies who carry out certain qualifying trading activities.
Immediate ownership: Unlike EMI options, growth shares confer immediate shareholder rights.

Example: Growth Shares in practice

Imagine a startup with a £5M valuation issues growth shares to a key employee with a £7M hurdle rate. The employee’s shares will vest over three years, provided they remain with the company. Upon a sale at £10M:

The employee benefits from the uplift above £7M, sharing in £3M of the value created.
If the employee leaves before vesting, the company will usually be able to redeem the unvested shares at the issue price (i.e. nominal value).

Conclusion

Growth shares with vesting conditions offer a compelling alternative to traditional equity incentive schemes, providing flexibility and alignment with company performance. While they require careful planning and legal structuring, their potential to reward and retain top talent makes them an attractive option for many businesses.

For tailored advice on implementing a growth share scheme, please get in touch with The Jonathan Lea Network via email at wewillhelp@jonathanlea.net or alternatively call 01444 708640.

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.