This paper is based on the law of the UK as of 23 November 2016. It should not be taken as legal advice but as an introduction into Vested Shares, the legal requirements of owning Vested Shares, and Vested Shares tax.
In the US, share vesting is a practice which legally exists and is common among businesses. On the other hand, in the UK vesting shares is not a widespread practice. Any UK business has to specifically write share-vesting clauses into contracts explicitly and in detail, as the process is not well known in the UK. Any doubts? Consult a lawyer!
For all you international readers, it is important to briefly touch on the different legal jurisdictions in the UK as the differing laws will ultimately impact your vesting arrangement with your fellow founders or employees.
- England and Wales: A jurisdiction with its own register of businesses.
- Scotland: Has its own register and slightly different laws regulating businesses behaviour.
- Northern Ireland: Has its own register and different employment and corporate laws.
What Are Vested Shares?
Vesting refers to the process by which an individual can earn shares/equity in a business over time (typically four years or fewer). It basically means you’ve served time in your business to the point where you gain the right to own stock. Think of it as issuing shares only when certain milestones have been achieved or some period of time has passed.
For example, if your business wanted to give you 50% equity through vesting, you would get given a percentage of that 50% regularly over a period, i.e. after three years you could own three-fourths (37.5%) of 50%.
Still a bit fuzzy? No worries.
Let’s say Regal is awarded 1,000 shares that vest over a five-year period. By the first anniversary of that share vesting, he is entitled to 200 shares but still cannot access the other 800 shares until the second, third, fourth, and fifth-anniversary dates. On just those dates alone, he is able to vest an additional 200 shares.
Vested shares also can be part of an overall compensation package at an established and publicly-traded company or part of your retirement package.
The most common equity vesting structure is:
- Founder terms: 4-year vesting, 1-year cliff, for everyone, including you and your employees.
- Advisor Terms (0.5 – 2.0%): four or two-year vesting, optional cliff, full acceleration upon exit.
A vesting-share cliff basically allows you to trial a hire without immediately committing to equity. You agree from the moment of the hire on the equity amount and vesting period. However, if they leave prior to the cliff period, (typically 1-2 years) then they receive no equity.
For instance, if they left the business within six months, they would get absolutely nothing. If the cliff period is included within the vesting period, a one-year cliff period and three vesting years, you gain 25% of your entitlement. After this cliff period is over, the process of vesting works exactly the same.
How to Vest Founders’ Shares:
62% of startups fail because of disputes between co-founders and founders.
It is vital that you get a Shareholders Agreement drafted by a legal professional as soon as possible to help regulate your relationship.
Setting up shares is a relatively easy process in UK. All you have to do is set your business up at Companies House or use company formation agents based in England.
Once registered, you need to talk with your other founder(s) to agree on an equity percentage. If Bill and Jane wanted to split a company 60% – 40% this means for every 6 shares Bill receives, Jane gets 4.
This is where it gets complicated. Once the distribution of equity has been sorted out, you then need to decide how many shares you will issue. For example if the business is worth £10, you could issue 10 shares, or you could issue a share which is worth 0.0000001 of a pound, meaning overall you issue 100,000,000 shares.
When you go through this process, your business can then start considering vesting the shares. This tends to solve many problems for startups especially when:
- You can’t pay an attractive salary.
- You want to fire someone if they’re not suited.
Let’s say your co-founder wants 10% of your business; you could either vest shares using time, milestones, or both:
- He gets 4% if he develops an Android app within three months (milestone);
- He gets another 4% if he releases the iPhone version of that app the following month (milestone);
- And another 2% if he works in the company for 12 months (timeline).
By using milestones, you ensure that the vesting of shares is results-driven, especially when the individual has overestimated his or her abilities. Let’s say the co-founder develops the Android app, works there for 12 months but doesn’t have the skills to develop the iPhone version; he gets 6%.
Employees and Vesting Shares:
For founders, vesting shares are traditionally used when bringing on a co-founder to ensure they don’t leave your business. The likelihood is, if the business is a success, founders will not leave. The same cannot be said for employees. The odds are that someone you recruit will not work out and leave after their allotted four-year period is over By accepting vesting on your shares, you have the moral high ground to insist on vesting of the people you hire, thereby protecting the company from a potentially bad hire, ensuring your workforce stays around to invest time in your business.
Offering your employees the prospect of vesting shares is of benefit to you, your business, and your tight purse strings. You don’t have to pay out a high salary, decreasing your cash flow. Your employee receives the benefit of either a potential windfall from vesting into an option or the direct benefit of vesting into shares. In addition, vesting encourages employee retention — few employees voluntarily walk away from the compensation potential that vested shares represent. They will be as happy as this guy…..
Employees, you have multiple options when considering vesting. It is important to bear the following in mind:
- Time: You may be required to hold the shares for X years before you’re entitled to them. The shares may be granted on a staggered basis over a period of time (known as graded vesting) or all at once (that cliff again).
- Event: Your right to them arises on a certain event such as an IPO or a change of control of the company
- Target: Personal or corporate performance target i.e. achieving a certain level of sales.
Typically the rate at which shares vest after the one-year cliff period tends to be one of the following:
If your employer does offer you share vesting, ask for written confirmation of the vesting arrangement and allow an experienced lawyer to ensure your interests are being protected.
The Legalities of Owning Vested Shares
The “Employee shareholder” shares (ESS), or Shares for Rights, legislation was were introduced in 2013 as a Government initiative meant to aid small businesses and startups in creating a more flexible workforce. Essentially, it allows companies to award at least £2,000 of shares to their employees on tax-advantaged terms, in exchange for the employee giving up certain specified employment rights. This legislation granted tax breaks to employees, granting them unlimited tax free gains on share sales.
However in 2016, amendments were added to restrict these tax free gains for shares issued before 16 March 2016. Gains after the relief have been restricted to £100,000 over the course of a lifetime. The arrangements are still worth considering because £100,000 of tax-free gains is better than none and because it is possible to agree the value of shares with HMRC in advance of acquisition (thereby de-risking the position for employees).
In order to qualify for tax breaks there are several legal requirements you must meet.
- Give no consideration or payment for the shares
- Be an employee, or be about to become one
- Be given prescribed information about the statutory employment rights
- Wait at least 7 days after receiving independent advice before the shares are issued.
Employees who have a “material interest” (own in excess of 25% of shares) can sacrifice employment rights in exchange for free shares, but will not qualify for tax reliefs (discussed below).
You must make sure the shares are:
- Newly issued and fully paid up
- Must be shares in the employer or an associated company
- May be subject to any vesting/forfeiture conditions
- May be any class (for example, non-voting growth shares are permitted).
Shares for rights are more generous than entrepreneurs’ relief as there is:
- No minimum holding period for the shares
- No minimum 5% nominal value and 5% voting requirement
- No requirement to remain in employment
- No need for the company to be a trading company
- No cap on the amount of the relief
The rights which an employee are required to surrender are:
- Unfair dismissal rights (apart from the automatically unfair reasons, where dismissal is based on discriminatory grounds and in relation to health and safety)
- Rights to statutory redundancy pay
- The statutory right to request flexible working except in the two-week period after a return from parental leave
- Certain statutory rights to request time off to train.
Tax on Vested Shares:
In 2016, new tax laws were created for share options. Now, you may not have to pay Capital Gains Tax on profits gained after the sale of shares. Ultimately, it depends on when you signed your employee shareholder agreement.
- If you signed before 17 March 2016:
You pay Capital Gains Tax only on shares that were worth more than £50,000 when you received them.
2. If you signed following the 17 March 2016:
You pay Capital Gains Tax only on gains more than £100,000 that you make during your lifetime. The ‘gain’ is the profit you make when you sell shares that have increased in value.
UK and overseas employees who have vested shares or are due to receive stock options will need to consider the impact of the rules.
However, if you spend time overseas than you may have to pay tax only on the profits made during the period you were in the UK. In order to do so, you must meet the new requirements:
- the employee is a UK resident and claims the remittance basis during any part of the relevant period; or
- Or, the employee was not a UK resident for some part of the relevant period;
- Or, the employee was subject to “split tax year” treatment during the relevant period.
Final Words: Get The Right Advice About Vested Shares
If your business is based in the UK, or you work in the UK, and have been offered vested shares, we would strongly suggest seeking advice. Contact Linkilaw for a vesting schedule and we’ll guide you through every stage of your legal needs.