Finding “market makers” for the private company.

By their very nature the market for shares in a private limited company is restricted.

The effect of the preemption rights included in the Articles of the majority of private companies will, for all practical purposes, restrict potential purchasers to other shareholders in the company, or, possibly, the company itself.

For many entrepreneurial businesses this absence of a market is not an issue: the “bargain” under which the shareholders hold their shares is that all work to build the business and benefit from the “market” they collectively create on an eventual sale, or possibly listing, of the company.

However this absence of a market may be an issue in “good leaver” circumstances or where the shareholding is in a business for which an exit event is not a conscious objective.

Before addressing the possible (and limited) solutions to the creation of a market in a private company, it should be recognised that the best solution is to avoid the problem arising at all.

In structuring any equity interest in a company for that important “second tier” of management and key employees it is best to avoid any immediate shareholding by the provision of share options.

Share options are not shares but rights to acquire shares.  Immediately the problem of creating a market in order to recover shares on a departure is eliminated as the options may (and probably should) be granted on terms that they can only be exercised on a defined liquidity event and otherwise lapse on termination of the employment.  If the nature of the bargain between the shareholders is that all equity holders are working toward an agreed liquidity event the early leaver should (save in exceptional circumstances) be held to that bargain.

The second benefit of share options is that, provided through an appropriate share scheme such as an Enterprise Management Incentive Scheme (EMI), they are very tax efficient giving the benefit of a favoured rate of capital gains tax on an eventual disposal of 10% with the benefit of entrepreneur’s relief.

Such a “preventative” course for a lifestyle or similar businesses is more difficult.  Objectively one might conclude that in the absence of any possibility of participation in a sale of the business there is little benefit in holding shares in a private limited company (not least the absence of a market!).  On this view a shareholding simply should not be offered.  While rational, this is a difficult position to maintain given the intangible incentives of ownership of the business. It also ignores the possibility of creating a market in the shares to deliver some capital appreciation to employee shareholders over their period ownership.

The difficulty here, as ever, is taxation.  A sale of shares pursuant to a sale of the whole company to a third party is clearly a capital transaction for tax purposes. The resulting gains are taxed at capital gains tax rates (currently 20%) and potentially 10% with the benefit of entrepreneurs relief.

In the absence of a third party sale any market that is “created” for shares in a private company will inevitably give a “connected party” transaction for tax purposes. Gains realised in such circumstances, while potentially taxable as a capital gain, may, unless very carefully structured give an exposure to income tax on some or all the gain realised (at rates potentially as high as 47%).

The simplest means of creating a market is to provide for the company itself to act as a market maker buying in the leaver’s shares.  With such comparative simplicity comes a potential tax cost.  The proceeds received for shares in excess of the sum originally subscribed will be taxed as a dividend. For a basic rate taxpayer a dividend rate of 7.5% may be acceptable: however 32.5% and 38.1% for higher and additional rate taxpayers respectively may be less so! (Although it is possible that the buy-in may be afforded favoured treatment as a capital gains tax transaction where the shares have been held for at least 5 years at the time of their purchase).

To avoid these tax issues the company may effectively sponsor a market maker (rather than act directly itself) by way of funding an employee benefit trust (EBT). The use of an EBT as a “market make” affords the opportunity for leavers to sell their shares as a capital matter to the EBT, with the EBT “recirculating” the shares acquired to existing employees and new hires, possibly utilising a tax efficient option scheme such as an EMI.

The tax sensitivity here is that any payment for the shares in excess of their open market value may be taxed as employment income.  This gives rise to a degree of uncertainty given the imprecision of share valuation (an art rather than science).  It may be possible over a period of time to agree a practical valuation methodology with HMRC which gives a degree of certainty in terms of the pricing of the company’s shares.   However such a modus vivendi with HMRC cannot be relied upon.

The market makers of last resort are the shareholders themselves.  The principal difficulty here is that the shareholders must fund their acquisition out of post-tax income and act collectively or risk disturbing their relative ownership percentages. Again a purchase of the shares in excess of their open market value gives an exposure to taxation as employment income, although any “incentive” for the shareholders to purchase the shares in excess of their market value will generally not be present.

The nature of any market depends upon those present in the market.  For all practical purposes those present in any market for shares in a private limited company is restricted to the shareholders themselves, the company or an EBT acting as an extension of the company.  Each of these is capable of providing a solution to the leaver problem—— but not always the optimum tax solution.

By Neil Simpson, tax partner at haysmacintyre


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