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SVM110050 - Tax Advantaged Share Schemes: Enterprise Management Incentives (EMI)

Guidance is available in the Employee Tax Advantaged Share Scheme User Manual at ETASSUM50000.

A qualifying employee of a qualifying company may hold unexercised tax advantaged share options (EMI and CSOP) with an unrestricted market value (UMV) of up to £250,000. The £250,000 limit applies from 16 June 2012; with a previous limit of £120,000 from 6 April 2008 and a £100,000 limit before that, subject to a total value of £3 million for all employees.

How to agree the value of the shares for Enterprise Management Incentives (EMI)

Some customers have asked for more detailed guidance on the correct valuation approach to EMI incentives and in consultation with external stakeholders, SAV has produced some simplified examples (below). SAV will consider the value proposed if a valuation of both the Actual Market Value (AMV) and Unrestricted Market Value (UMV) for any shares under options is submitted with form VAL231. SAV should not be approached until the company is actually in a position to grant the EMI options. EMI valuations are given priority upon receipt in the office. If we need to discuss the valuation further, then they are treated in line with other correspondence. We will consider a check before the options are granted and during the 12 months and 92 days after the options have been granted.

Valuations for EMIs are valid for 90 days from the date of the agreement subject to the proviso that there are no changes in the Company’s circumstances that might affect the value of its shares prior to the options being issued. If the options have not been granted within this time frame applicants will be required to submit a fresh application with a newly completed form VAL 231 .

Valuations submitted undergo an initial risk assessment and only a proportion receive detailed examination, those considered lower risk will receive a limited without prejudice acceptance. Some agents have raised concerns over HMRC accepting some unrealistically low EMI valuations on a without prejudice basis. Such low values are sometimes queried by potential company purchasers during due diligence, causing potential delays or difficulty in company sales. The agreement of EMI valuations is a voluntary service provided by SAV; therefore, we are not obliged to agree a valuation for EMI purposes and SAV will not enter into protracted correspondence. Applicants may grant the options without the value being agreed.

In accordance with the valuation hierarchy, familiar in accounting, there is often no better indication of value than actual transactions involving the same or similar asset. When considering the open market value of the company’s shares, the valuer should first ascertain whether there have been any recent transactions in those shares, the frequency of trades and any factors peculiar to those exchanges. An initial investment by an external investor with preferential rights may require substantial adjustment. If there are more frequent exchanges either between employees or unconnected small investors the prices paid may provide a reliable guide to current market value.

In the absence of an active market and any recent transactions, the use of an appropriate valuation technique would be employed.

Any recent transactions provide an indication of value including any restrictions, that is, the Actual Market Value. The Unrestricted Market Value is the value without taking any such restrictions into account. The AMV and UMV should always be considered. However, it is sometimes suggested by applicants that restrictions, such as those on transfer, do not depreciate value. The same price for both AMV and UMV is therefore proposed. Both values do not need to be agreed provided the price agreed represents at least UMV and options are granted at that price. There is then no need to agree an AMV.

Valuing unquoted shares can be complex, but for small companies that may need to do a valuation, we’ve provided some illustrative examples below. These examples are not definitive or exhaustive and apply to companies with the most straightforward circumstances.

Start-up company A – a technology-based company with no trading history

The issued share capital is made up of 2 million shares.

1p A ordinary shares = 200,000 1p ordinary shares = 1,800,000

Both types of shares have equal rights apart from:

  • the A shares having the right under the company’s articles of association to appoint 2 directors to the board
  • the A shares come before the ordinary shares on a return of capital
  • the ordinary shares are subject to risk of forfeiture and pre-emption provision

All the A shares are owned by an external investor who paid £2 million for them, or £10 per share.

The company now wants to grant EMI over a pool of 10% of as yet unissued shares to its employees.

There is no sale or flotation planned in the near future, but the company plans for this to happen in the next 3 to 5 years.

It needs to provide valuations for Actual Market Value (AMV) and Unrestricted Market Value (UMV) of the ordinary shares at the date the EMI options are granted.

The company has no trading record. The assets consist of the balance of the cash from investment and some intangible assets.

A reasonable and tangible starting point to value the ordinary shares may be to look at the price paid for shares by the investor. the figure would require adjustment to reflect.

Preferential rights of the A shareholders

Changes in market conditions since the initial investment.

Changes in company business plan.

The company could reasonably discount that price by at least 30% as these shares carry fewer rights and possibly substantially higher, depending on the exact fact pattern. This would indicate an AMV of £7 per ordinary share.

When calculating UMV you should ignore the risk of forfeiture and pre-emption provision and so a 10% premium might be reasonable. This would indicate the UMV is £7.70.

Start-up company B – a company with no external investment

In this scenario, all the initial capital is provided by the founder shareholders. 2 people invest £50,000 of their own money and receive 50,000 £1 shares in return. The issued share capital is then 100,000 £1 ordinary shares.

To build the business, the founders want to recruit but as they cannot afford commercial salaries for the new employees, they want to give them EMI over a pool of £10,000 shares in total.

Like start-up company A, the company has no trading history and very few assets. So, in this case, it could be reasonable that the employee shares are valued the same as the founders’ shares at £1 per share. As in example A, it may also be reasonable to discount this if the founders have some preferential rights over and above the employees, according to the company’s articles of association.

Established trading company - with no external investment

This company:

  • has been trading for around 10 years
  • wants to incentivise employees by granting them a pool of up to 5% of the company’s enlarged share capital
  • is not in the process of a sale or flotation

To establish the AMV and UMV, the management accounts for 2012 have been used as the last published accounts (to November 2011) are considered stale by the company at the valuation and it’s reasonable to take into account more up to date information.

  Full audited accounts to November 2010 Full audited accounts to November 2011 Management accounts to November 2012
Turnover £6.5m £7m £7.5m
Post tax profit £525k £600k £600k
Dividends paid £1 per share £1 per share £1 per share
Dividend cover 2.62 3 3

If all possible sources of conversion exercised their options, the fully diluted share capital would be 200,000 £1 ordinary shares.

To get an idea of the AMV, the company needs to know or work out the:

  • earnings per share
  • dividends per share
  • price-earnings ratio – a valuation ratio of the company’s current share price compared to its per-share earnings
  • dividend yield percentage

From its accounts record, maintainable post tax profit (earnings) are £600k per year. This would mean earnings per share of £3.

Dividends are maintainable at £1 per share and are well covered.

To get an idea of the price-earnings ratio, the company looks at a quoted company on the full London Stock Exchange in the same market. It shows a price-earnings ratio of 12.03.

To reflect the differences between a minority holding in this company and the quoted company, the company discounts this price-earnings ratio by around 60% to 65%. This gives a final price-earnings ratio of 4.5.

To work out the AMV the company then multiplied the price-earnings ratio of 4.5 by the earnings per share of £3: 4.5 x £3 = £13.50.

This value can be cross checked by looking at the dividends payable. To work out the dividend yield the company looked again at the same quoted company which had a dividend yield of 3.40%. The company then increased this by a multiple of around 2, again to reflect the differences between the companies. The revised yield percentage is 7.4%.

The same AMV is achieved by dividing the maintainable dividend of £1 per share (equal to 100%) by the dividend yield of 7.4%:100 ÷ 7.4% = 13.5.

To work out the UMV, the company adds on around 20% to the AMV to give a value of £16.20 per share. This reflects that the Articles of Association for the company give the Board full veto on any share transfers and this and other restrictions should be ignored when calculating UMV.

Using other multiples instead of a price-earnings ratio

A multiple (of profits) can be used in place of a price-earnings ratio to calculate share value. You can work out the multiple by looking at the sales of companies – both private and quoted – in similar markets to the company under consideration.

To make sure any implied multiples are, so far as possible, reliable and comparable, you must carry out careful research of the terms of these companies’ sales beforehand.

If the company has a high level of debt on its balance sheet, which reduces any post tax profits substantially, the value of its shares can be arrived at by reference to an Enterprise Valuation (EV) looking at its maintainable Earnings Before Interest Depreciation and Amortisation (EBITDA).

It is then possible to apply an EBITDA multiple from a comparable quoted company. Deducting the company’s debt from the resulting EV will then leave the Equity Value, from which the minority share value can then be assessed, applying appropriate discounts.

Whilst EBITDA multiples for quoted companies are not available in publications such as the Financial Times, these can be calculated by the valuer, usually by adding a particular quoted company’s market capitalisation to its long-term debt, to arrive at its EV.

The EBITDA for the quoted company can then be calculated by reference to its accounts and dividing the EV by the EBITDA, to give the multiple. It can then be appropriate to discount the quoted company’s EBITDA multiple to reflect the differences between the quoted company and the unquoted company which is being valued.

EV to EBITDA multiples can be found in the BDO Private Company Price Index (PCPI) which tracks the relationship between the EV to EBITDA multiple paid by trade buyers when purchasing UK private companies. The PCPI was updated in 2013 to incorporate EV to EBITDA multiples as the method of valuation, replacing the previously used Price to Earnings ratio.

Multiples can also be found in the private company Price Earnings Ratio Database (PERDa) compiled and analysed by members of the Leading Edge Alliance, a global alliance of major, independently owned, accounting and consulting firms.

The PERDa provides information on the pricing of private company sales and acquisitions. It shows the quarterly movements in the average Price Earnings Ratio (PER). This ratio measures the relationship between the consideration (price paid) for private companies and their underlying profits on an adjusted basis and includes the average PER based on Earnings Before Interest and Tax (EBIT) and Profit After Tax.

Note: Both the PCPI and PERDa are average measures and act as guides, and not as absolute measures of value, as there are many significant factors that can have an impact on value.

Depending on the starting point it may be appropriate to adjust the multiple to reflect factors such as comparable sales, trading activity, industry standards, age of the business, reliance on key personnel etc.

Company with imminent Alternative Investment Market (AIM) flotation

A previously private computer software company is planning to float on AIM in the next 2 weeks but wants to grant EMI options to employees first.

The price that investors are invited to buy shares at, which will also be the opening price on AIM, will be £2.50 per ordinary share.

The employees will be granted EMI options over the same ordinary class of share as will be floated on AIM, but there will be individual performance targets in their option agreements that will determine when they can exercise their options.

A small discount may be appropriate, depending on the facts, to reflect any risk that the float may not go ahead in the scheduled time frame.

It may therefore be reasonable to use the price of £2.50 per share or, subject to the above factor, very close to this, as both AMV and UMV for the purpose of granting the EMI options.

There’s no need to adjust or discount (for a valuation for option purposes) to reflect the performance conditions restricting the employees’ freedom to exercise their options, as these conditions are personal to the employee only.

Company in talks over a sale

A component production company is in talks with a competitor business for a sale of the company. The sale price, subject to due diligence, is likely to be made up of cash and a small earn-out element.

In anticipation of a sale, the company wants to grant EMI options over 10% of the fully diluted share capital to its employees.

The exact sale proceeds are not known but the likely range equates to £20 to £22 per share on a pro rata basis.

In the light of the impending sale, it’s reasonable to value the shares over which options will be granted to the employees by reference to the possible sale proceeds per share.

Depending on the level of risk, uncertainty over the final amounts payable and also the timing, it might be reasonable to apply a discount in the range of 20% to 40% indicating a share value of around £12 to £17.60 per share for the EMI options. It will depend on the specific circumstances of the company as to whether a differential is required between the AMV and UMV.

Rosalind Ltd - A loss making technology/development company

Rosalind Ltd is an independent unquoted company which is seeking to develop ground-breaking medical therapies and products. It is loss making and has no revenue. It relies on injections of cash through share subscriptions, primarily by professional investors (for example, institutional investors such as a private equity company or financial institution) for its continued operations. The future success of the business is not only dependent on achieving commercial success for its therapies and products but also its therapies and products passing rigorous clinical tests and securing key regulatory approvals. Rosalind Ltd wishes to incentivise employees through equity participation over its Ordinary shares.

The professional investors have subscribed for a different class of share which through a combination of the articles and other arrangements such as shareholder agreements, give these shareholders a package of rights which the Ordinary shareholders do not enjoy. These shares rank ahead of the Ordinary shares on a pay-out to shareholders such as a liquidation, share or asset sale or return of capital and their shareholders have the right to appoint specific directors to the Board and must consent to major changes in the running of the business. They also give the investor shareholders access to management information and the right to subscribe for further shares in priority to other potential investors.

Because the company is loss making and has no revenue, and any financial projections at this stage cannot be anchored in historical financial performance, conventional earnings-based valuations are not possible for assessing the market value of the Ordinary shares. The balance sheet of the company does not provide a basis for valuing the company as, in accordance with accounting standards, it does not include the value of the intellectual property the company may have developed and mainly consists of cash obtained from shareholders which is earmarked to fund the operations of the company. The only transactions that have occurred to date were the subscriptions made by the professional investors in the Investor class of shares, which may provide an indication of value of the Ordinary shares.

Although the goal of the founders and investors is to seek a realisation event such as an IPO or sale of the company within the next 3 to 5 years, the company has not been in discussion with any potential purchaser, there is no sale or flotation planned in the near future and no corporate finance house has been engaged to assist with a sale or IPO.

While the price paid by the investors for funding the company might give an implied value for the Ordinary shares over which options are to be granted, the following factors (which are not meant to be exhaustive) may have a bearing:

  • The different rights of the shares held by the investors – including possible limits or control on the level of senior management remuneration
  • The nature of a development company and its reliance on future successful commercial exploitation of a market for its products and regulatory approvals
  • The potential for the continued need for equity funding for the company to be able to remain in business while it is in its developmental stage
  • Risk and reward - often a very low entry cost for some share classes, but with the prospect of high returns in the future; and
  • The spread of investors and the number of shares acquired by them.

The effect of these factors on the value of the Ordinary shares will vary from case to case but it may be reasonable to reflect a potentially significant discount in the valuation of a small minority holding of the Ordinary shares over which options are to be granted. In most cases it is probable that the Ordinary shares will have an actual market value (“AMV”) greater than their nominal value. The unrestricted market value may then sit at a premium to the AMV.

EOT Company (“PAMELA”)

Pamela Limited is an owner managed business which was founded by its CEO Ms Pamela Smith. Pamela Limited has grown steadily since it was started 20 years ago.

1) Ms Pamela Smith is looking to retire in a few years’ time and in the meantime would like to scale back her involvement with the business. From time to time the business has received approaches from potential purchasers but Ms Pamela Smith would prefer Pamela Limited to continue to be independent after she retires and be run by the management team and employees who have helped her build the business.

2) A couple of years ago she arranged for the company to issue free shares to all the employees under the government’s Share Incentive Plan (SIP). The result was that Ms Pamela Smith held more than 95% of the company’s single class of ordinary shares and the employees held the remaining shares through the SIP.

3) Valuation of the ordinary shares was agreed with HMRC for those SIP awards. This involved a theoretical calculation of the value of Pamela Limited of £3M based on a multiple of profits, with a large discount for the individual shareholdings being very small, uninfluential minority holdings in an unquoted company.

4) A few weeks ago Ms Pamela Smith converted Pamela Limited into an Employee Ownership Trust (“EOT”) owned company under FA 2014 Schedule 37 rules by selling 70% of the Ordinary shares to the EOT, leaving her with over 25% and the employees holding the balance of the shares.

5) The sale of the 70% holding involved a Sale and Purchase Agreement. (“SPA”) between Ms Pamela Smith and the EOT. The total maximum potential consideration for the sale of the 70% holding was agreed between Ms Pamela Smith and the trustees at £2.8 million based on a multiple of profits but with much of the consideration being deferred and dependent on the generation of future distributable profits and surplus cash after the change to EOT ownership. As a controlling interest was being sold there was no discount, unlike for the earlier SIP awards.

6) Under the SPA £800,000 is payable to Ms Pamela Smith immediately on completion from available cash and distributable profits. The balance of the maximum further potential consideration of £2 million is anticipated to be paid in 5 annual instalments of £400,000 over the next 5 years.

7) These instalments will only be paid, if in the future, the now EOT owned company generates sufficient surplus cash and profits to be able to gift money to the EOT to allow the anticipated instalments to be paid by the EOT to Ms Pamela Smith. If there are not sufficient distributable profits and cash generated in the future some or all of the consideration in excess of £800,000 cannot be paid to Ms Pamela Smith.

8) During the transitional period, while there is outstanding consideration due to Ms Pamela Smith, future profits of the company will be required to fund the paying off by the EOT of the consideration due to Ms Pamela Smith. As a result, the potential for employees to receive dividends on their direct shareholdings is limited. But to deepen the employees’ sense of ownership and responsibility, after the conversion to EOT status, direct employee share ownership is being increased by a new issue of free shares under the SIP. But these will be small minority holdings and control will remain with the EOT.

9) In the future after the end of the transitional period when the trust’s obligations to the EOT have been fully discharged and future profits are fully available for shareholders it may then be appropriate to value further SIP share awards on a dividend basis of valuation.

10) But, as the fundamental economic nature of Pamela Limited’s business has not changed following the conversion to EOT ownership, while future profits will be needed to fund the EOT’s obligation to Ms Pamela Smith, a valuation based on a multiple of profits continues to be more appropriate with a discount for SIP shares being small uninfluential minority holdings in an unquoted company. However, depending on the repayment terms attaching to the outstanding balance of the consideration due to Ms Pamela Smith, this theoretical valuation of Pamela Limited may also need to take into account the company’s likely future cash flows and its non-contractual obligation to fund the EOT from future profits to allow the EOT to pay the outstanding balance.

Additional Guidance:SVM150000