Arthur Crocker, chief financial officer at mobile marketing company Adfonic, explores George Osborne’s employee ownership scheme in comparison to the original Enterprise Management Incentive Scheme.

The Enterprise Management Incentive Scheme (EMI Scheme) in its original guise was a powerful instrument with which a small entrepreneurial company could realistically seek to attract high quality (and therefore probably expensive) staff without having to fund the full market salary for such individuals.

It did this through offering a combination of tax reliefs on the grant of qualifying options in the shares of the employing company. Relief ranged from income tax and national insurance on grant and, subject to certain conditions, also from income tax and national insurance on exercise.

Most importantly, the old EMI Scheme also offered tapered relief from capital gains tax on the ultimate disposal of shares obtained by exercising the option, down to an effective capital gains tax (CGT) rate of 10 per cent. Unfortunately, the taper relief was removed in the 2007 budget, and the CGT rate now applicable to a realisation under EMI Scheme rules is the same as for other gains – currently 28 per cent.

This change had the effect of removing the main advantage of the scheme, and therefore made it a less effective retention and recruitment tool for small and medium-sized companies. It is worth considering some parallels between the EMI Scheme and George Osborne’s recently announced proposal to allow businesses to remove certain employment rights in exchange for giving employees shares (worth £2,000 to £50,000). Under Osborne’s scheme employee shares are exempt from Capital Gains Tax, which has been designed with SMEs in mind.

Fast growth followed by an exit

The EMI Scheme (as originally conceived) was aimed at entrepreneurial companies, whose objective was fast growth followed by an exit. Without an exit, the options would not generally be triggered and would therefore be of little value.

Similarly, under the Osborne proposal, although it appears that shares rather than options would be granted, without either an exit or some sort of realisation mechanism (eg share buy-back by the company), such shares would be of little practical value. The logic being that shares would likely represent a small stake in a private company, and typically would not be freely saleable due to restrictions under the articles, even if a buyer could be found.

Universality

Valuing small private companies is always an inexact science and tends to be more opinion than fact. Under the EMI Scheme, employee participants will have entered into the arrangements in the knowledge that the outcome is at best uncertain and therefore will have made a calculation of whether accepting a lesser salary will be compensated by the possibility that a significant gain might be made.

These arrangements would tend to suit a particular type of individual willing to accept risk rather than being suitable for everyone. The Osborne proposal is apparently applicable to everyone, and although it is proposed that existing employees have the chance to opt out, new employees will fall compulsorily under the scheme.

Value

Presumably, the quantity of shares to be given under the Osborne proposals will be related to the potential cost to the company and benefit to the individual of each individual’s rights under UK law for unfair dismissal, redundancy, the right to request flexible working and time off for training, since the individual will be required to give up these things.

Such issues are reasonably well understood and quantifiable. As alluded to above, the value of a modest parcel of shares in a small or medium-sized private company is highly uncertain, and will be significantly affected by, inter alia, the performance of the company, the economic environment, the prospects for the future, and decisions taken by management or owners about significant discretionary costs such as their own remuneration.

The individual is therefore being asked to give up reasonably certain cash rights for uncertain future value which may be significantly affected by management and owners. Consideration will need to be given to significant anti-abuse provisions relating to manipulating value and financial performance.

Dividends and votes

Many private companies do not pay dividends or only pay them intermittently as circumstances and performance allows. Some use different classes of share. If it is intended that employee share owners under this scheme enjoy the full benefits of share ownership, then rules will be required to deal with the possibility of the employee shareholders having disadvantaged rights.

Good leaver/bad leaver

If an individual is required to leave for gross misconduct, he or she may well leave without compensation. Under the proposed scheme, would there be a mechanism to remove the employees share rights? In addition it is often the case that more complex arrangements will be contained within shareholder agreements – it is yet unclear whether there will be shareholder agreements governing these employee shares.

In summary, it appears likely that these proposals may suit a number of people in particular types of companies (generally those people and companies that would have been appropriate for the old EMI arrangements).

However, for what is likely to be a significant majority of people, they are unlikely to be viewed favourably as an equitable exchange, and there are significant administrative and anti-abuse issues to consider, which may make the proposals costly and difficult to implement.

If you believe that the current position does not strike the right balance, how about making legislative adjustments to UK law to produce a more equal balance between employer and employee, and restoring the original arrangements of the EMI Scheme to benefit and reward those sections of the working population who are comfortable with that level of personal risk instead?

It should be possible to frame the qualifying rules for EMI Schemes in such a way as to prevent abuse, and the scheme would become a more powerful retention and recruitment tool to enable entrepreneurs to recruit key staff and grow the SME sector of the economy.

See also: The pros and cons of employee ownership trusts (EOTs)