Founder equity:
how to rebalance a cap table after a down or flat round and top up the management team

Published: 25 October 2022


Route 1 for founders of UK tech ventures invariably involves subscribing for shares in a new limited company on incorporation before navigating through a series of equity funding rounds at exponential valuations before cashing out a significant percentage shareholding at exit.

That’s usually the plan, anyway.  But funding rounds with a flat valuation and the dreaded ‘down round’ will usually see the size of the founders’ percentage shareholdings much diminished and perhaps with them the dream of life changing returns at exit.  That can be a particularly unpleasant experience if the valuation of the round has triggered an anti-dilution ratchet.

But if the company has to raise the funds and doing so at a sub-optimal valuation is the only offer on the table, then the founders seldom have much choice but to go along with it and suffer the dilution.

Or do they?  There are ways in which founder equity can be topped up, for example by using a structure where returns to the founder from the additional equity are driven only by value accrued from the point in time of the top up. This may align with the investors’ perspective whilst at the same time avoiding the obvious tax problems that would otherwise bite where valuable equity is given to employees for free or at less than market value.

The means of achieving this are never completely simple.  There may be a number of complicating factors such as the need to balance the interests of founders and investors, valuation considerations and (given the complex nature of the task at hand) the cost of the advice.  However, before you throw founder equity top ups into the ‘too complicated’ basket – which often happens – make yourself a cup of tea and read on below.

This Insight piece was written and researched by Annette Beresford with input from Henry Humphreys, Jeremy Glover and Sanya Bhambhani.

Founder equity

How to rebalance a cap table after a down or flat round and top up the management team

Founder equity

How to rebalance a cap table after a down or flat round and top up the management team

You will need buy in from the investors

Before getting into the detail of how to do it, founders will need to have convinced their investors that a top up of some description is required.  Room for that top up will need to be found on the cap table.

In the context of a down or flat round, the argument that can be put to investors is that the top up equity will be for ‘growth’ and will give management greater incentive to grow the business by returning value created after the date of the top up (but not diluting investor returns below the current value plus usually a buffer amount of some kind).

If the investors go for that, then the next step is to work out how to structure it without picking up nasty dry tax charges for the founders and the investee / employer company.

And – as should become blindingly obvious by the end of this Insight piece – you are going to need professional advisors engaged from the outset and be prepared to stomach the costs.

Be aware of the tax regime for 'employment-related securities' ('ERS')

The ERS tax regime applies to founder equity in the same way as it does to equity held by other employees or directors.  Founders are no exception.

The legislation does not recognise the concept of ‘founder shares’.  This means that any receipt of value in the form of equity by a founder (less the value of any consideration provided (price paid) by the founder for the relevant equity) may be treated as employment income subject to income tax and potentially also National Insurance contributions (‘NICs’).

The exposure here is for the founder personally, but also for the company as employer – the company has primary liability as regards any PAYE liabilities and pays any applicable employer’s NICs.

Valuation of founder equity

The amounts of tax at stake could be considerable, given that the need for a founder equity top up typically arises when the company is already past its start-up phase and has closed at least one investment round.

Using the price per share most recently paid by a third-party investor as a starting point may result in an unfeasibly high valuation for tax purposes, even after factoring in relevant discounts for minority holdings and being at the bottom of a preference stack.

Even on a major down round, the paper value of the equity may still be considerable.

... and the timing of the tax valuation and the trigger for tax liabilities is key

The concern is not only the overall amount of the potential employment tax liabilities, but also the time when such liabilities are crystallised: at the time of the top up (when the equity or right to acquire equity is received) or at a future exit (when value is received).

A founder will absolutely want to avoid triggering a large upfront tax liability at a time when an exit (and thus a realisation of value) is still a long way into the future (a ‘dry’ tax charge), with no guarantee that a successful exit will eventually be achieved.  For example, if the company later became insolvent, this would not reverse any employment tax liabilities triggered at a previous chargeable event by reference to what was considered to be the market value of the relevant shares at that time.

Ways of structuring around 'dry' tax charges

We consider below the following four approaches which can be seen as alternatives but can also be used in combination in certain scenarios:

  • Enterprise Management Incentives (‘EMI’) options over ordinary shares of an existing class.
  • EMI options over growth shares (and issues of growth shares vs EMI options over growth shares).
  • Unapproved options.
  • Nil-paid shares.


Some disclaimers before we go on

Note that this Insight piece does not aim for completeness and that there is a range of additional alternatives that could be explored, although they tend to become increasingly exotic once you go beyond the four mentioned above.

Note also that this Insight piece does not consider the use of a Company Share Option Plan (‘CSOP’), a type of share plan which confers similar tax benefits to EMI options, but with different qualifying criteria.  With the increased CSOP limit and simplification to the CSOP rules announced at the 2022 September ‘Mini Budget’, CSOPs are likely to increase in popularity in the future, in circumstances where the EMI qualifying criteria are not met.

This Insight piece further assumes that a founder receiving an equity top up is resident in England and within the scope of UK employment taxes.


EMI options

EMI options for founders - qualifying conditions and "material interest"

EMI options are usually a preferred choice for providing equity incentives to employees where the company qualifies for EMI, as they are tax efficient and relatively straightforward to manage. Note that there are circumstances where they are not the preferred route (such as where there is a likelihood of an exit not happening during the ten-year period of the EMI option).

Where EMI options are granted with an exercise price that is equal to or above the underlying shares’ market value (as at the time of grant), any gains realised on exercise (being the difference between the shares’ market value at the time of exercise and the exercise price payable) are not treated as employment income subject to income tax and NICs as would be the case on the exercise of an ‘unapproved option’ (on which see further below).  Instead, such gains are subject to capital gains tax (‘CGT’) when the shares acquired on exercise are sold. Where exercise is triggered by an exit event, exercise and sale may happen in very short succession.

As things stand at time of writing, CGT treatment is preferable to income tax treatment, with the current top rate of CGT on a disposal of shares being 20%, compared to higher rates of income tax and NICs for higher or additional rate taxpayers (currently 40% and 45%). The rate of CGT may be further reduced to a mere 10% depending on the amounts of the gains made by the founder where business asset disposal relief is available (there is currently a £1 million lifetime limit).  Subject to such limit, business asset disposal relief is usually available where shares have been acquired through exercising EMI options and at last two years have elapsed since the time of grant.

For a company to be a “qualifying company” for EMI, it needs to meet a number of conditions, including requirements to:

  • be independent (i.e. not controlled by another company or a partnership involving another company);
  • be a trading company or the parent company of a trading group (with such company or group not carrying out a significant amount of “excluded activities”);
  • have gross assets not exceeding £30 million;
  • have fewer than 250 employees; and
  • have a UK permanent establishment.

The concept of “excluded activities” is used to focus the benefits of EMI on early-stage companies that are not asset backed or operate in certain lucrative sectors (such as dealing in land, financial services, legal and accountancy services) which should not normally require extra help in attracting and incentivising key staff.

For an employee or director to be able to receive EMI options, they must work for the company (or group) for at least 25 hours per week, or if less, 75% of their working time.  Further, they must not have a “material interest” (30% or above) in the company or any of its subsidiaries (looking at beneficial ownership of the company’s shares as well as entitlement to receive assets on a winding up).  These requirements are tested at the time an EMI option is granted.

The “no material interest” requirement is often an issue for founders that stops them receiving EMI options even if the company qualifies.  Although we may be looking at a founder equity top up precisely because the founder’s stake has dropped lower than the founder is comfortable with (which could be below 30%).

If the company qualifies for EMI and the founder’s existing equity stake does not breach the “no material interest” requirement, we can move on and consider whether EMI options can be granted over a sufficient number of shares, having regard to the limits for individual grants of EMI options.

Granting EMI options over an existing class of ordinary shares

Grants of EMI options are subject to certain limits.  There is a £3 million overall limit on the value of shares in a company that can be subject to unexercised EMI options, and a limit of £250,000 on the value of unexercised EMI options that can be held by an individual employee.  Further, an employee who has been granted EMI options with a total value up to the EMI individual limit cannot receive further EMI options for a period of three years.  Each such limit is applied by reference to the market value of the underlying shares as at the time of grant, but ignoring any restrictions on the shares.

Depending on valuation, fitting a sufficient number of an existing class of ordinary shares into the £250,000 limit might be a challenge.  The founder might have a specific number of shares in mind for the equity top up, and the price per share paid at the most recent investment round may result in the relevant shares’ unrestricted market value being too high to accommodate such number of shares within the limit (even after factoring in minority discounts and the effect of rights attributable to other (more senior) share classes).

In addition, in order to realise the full tax benefits of EMI options, the exercise price must not be below the underlying shares’ actual market value (this time taking account of relevant restrictions) at the time of grant.  While this rule aligns with the interests of investors by confining the EMI tax benefit to future increases in value, a high exercise price may look unattractive to a founder, and the difference between the unrestricted market value and the actual market value, by reference to the impact of relevant restrictions, may not be straightforward to establish in practice.

EMI options over growth shares

Granting EMI options over a new class of growth shares

A new class of ordinary shares (‘growth shares’) could be created with a lower market value than any existing class of ordinary shares.  The new class of growth shares would only participate in exit proceeds above a specified ‘hurdle’ which is set above what is considered to be the company’s current market value.  So, holders of growth shares only participate in future growth, which means that the market value of those shares is considerably lower than that of existing ordinary shares.

Precisely where the hurdle should be set to achieve a sufficiently low value of the growth shares is a valuation matter.  The tax treatment of growth shares depends on getting the valuation right, which is a matter of evidence as much as anything else.  Commercially, there is a tension between setting the hurdle high enough to be reasonably ‘safe’ for tax, but not at an amount that realistically is not achievable (which would defeat the objects of the top up from the founder’s perspective).  For those reasons, it is always recommended that valuation advice is obtained from a professional valuer (and retained on file) before any kind of growth shares scheme is established.

Where growth shares are used for granting EMI options, it is also possible to agree the valuation with HMRC beforehand.  Again, this is something that should be done, not least because future investors or a future buyer will usually ask about this in due diligence.

Assuming the growth shares are ordinary shares that comply with EMI rules (for that, shares must be part of the company’s ordinary share capital, be fully paid up and be non-redeemable), they can be used for granting EMI options.  This could be grants of EMI options to senior staff as well as a qualifying founder.

It should be noted that the use of growth shares, while recognised as fairly mainstream, is considered more adventurous in terms of planning.  Although HMRC have not so far challenged the use of growth shares as a concept, particular care should be taken with regard to valuation and meeting the EMI qualifying conditions (where growth shares are used for EMI).  Where a company has also issued, or is planning to issue, shares under Enterprise Investment Scheme (‘EIS’), care also needs to be taken to ensure that a new class of growth shares will not inadvertently give EIS shares a preference that would invalidate EIS relief.

An outright issue of growth shares versus EMI options over growth shares

A possible alternative to granting EMI options over growth shares, e.g. in circumstances where the company does not qualify for EMI or the founder has a ‘material interest’ (see above), would be an outright issue of growth shares.  Instead of receiving an EMI option over growth shares that would be exercised immediately prior to exit, the founder would receive top up equity by simply subscribing for growth shares.  Under company law, the subscription price must be at least equal to the shares’ nominal value, but it is the tax valuation which is interesting here.

To avoid a tax charge at the time of subscription, the founder should acquire the shares for a subscription amount that is equal to what is considered to be the shares’ unrestricted market value.  For this to be affordable, the growth shares hurdle will need to be set sufficiently high.  The company could also provide the founder with assistance to facilitate the acquisition, e.g. in the form of a loan or bonus, which company law permits in the case of private companies.  Note, however, that a beneficial loan will itself be a taxable benefit and that a bonus will be subject to employment taxes in the same way as normal salary.

Assuming the founder pays unrestricted market value for the shares and also enters into an election with his employer company to disapply the tax regime for ‘restricted securities’ (a ‘section 431 election’ which can only be entered into within 14 days of the shares’ acquisition), the tax treatment of future increases in the shares’ value should be very similar to the EMI tax treatment outlined above in terms of substance.  Future increases in value would again be treated as capital subject to CGT (and not as employment income subject to income tax and NICs), with the CGT charge only arising when the shares are sold.  Of course, this also assumes no challenge from HMRC (for example, with regard to valuation).

In terms of differences:

  • The founder would be the registered holder of any growth shares issued outright, as opposed to merely having an option to acquire them. Administrative issues aside, this may not make much difference in practice.  Growth shares are usually designed as non-voting and non-participating in dividends, to make valuation more straightforward, in which case holding actual shares as opposed to options would not confer those additional benefits of share ownership.
  • If the unrestricted market value of the growth shares (while below that of existing ordinary shares) comes out higher than trivial, the subscription price for an outright issue of growth shares would need to be funded (see above). In the case of ‘exit only’ option, the exercise price can be funded from the exit proceeds.
  • Where growth shares are used for EMI options, HMRC will agree a valuation.  They will not do this for an outright issue of growth shares. If growth shares are also used for granting EMI options, a valuation agreed with HMRC will technically only apply to the option grants.  Naturally, it will still provide a certain amount of comfort for an actual issue of growth shares of the same class, assuming it happens at the same time / while the EMI valuation remains valid.
  • Unlike gains made by UK employees on their share options such as EMI options, future increases in the value of growth shares acquired by UK employees do not give rise to a statutory corporation tax deduction for the UK employer company.

Unapproved options

The main benefits of unapproved options are that (i) they are very easy to implement, and (ii) no employment taxes arise at the time of grant (assuming the recipient of the grant is an employee or director), regardless of how low an exercise price is set.  Note that, for company law reasons, the exercise price should not be set below the underlying shares’ nominal value.

Assuming the option is ‘exit only’, employment tax liabilities arise only when options are exercised at an ‘exit event’ and can be met from exit proceeds.  Because of those benefits, unapproved options tend to be the default choice where the EMI qualifying criteria are not met and the creation of a separate class of growth shares is not feasible or considered too risky.

The downside of unapproved options is that they are not tax efficient.  The full gain (difference between market value on exercise and exercise price payable by the option holder) will be taxed as employment income and thus be subject to income tax and NICs (including employer’s NICs).  So, while the tax bill would be postponed until a time when there are proceeds available to pay it, it would then be expensive – the more successful the company is, the higher the employment tax liabilities.

A point for investors is that, where an unapproved option is granted over shares of an existing class, such shares will participate in exit proceeds in accordance with the rights attaching to such existing class under the company’s articles.  Where investors wish to restrict a founder’s participation from the top up so that it is limited to future increases in the company’s value, this could be done by setting an appropriate exercise price.  Alternatively, the terms of the option could include performance conditions which determine the number of shares in respect of which the option is exercisable by reference to specified factors, such as the size of the exit.

Nil-paid shares

Nil-paid shares are typically used in circumstances where the EMI qualifying criteria cannot be met in full and the creation of a separate class of growth shares is not feasible, but the parties still wish to achieve capital treatment (rather than go down the route of ‘easy, but expensive’ unapproved options).

Nil-paid shares are usually ordinary shares of an existing class which are issued at full price (i.e., at a price equal to the shares’ unrestricted market value), but without collecting the subscription amount from the subscriber until an exit or other specified event occurs (such as a sale, IPO, liquidation or a compulsory transfer by a leaver).  Investors may be prepared to agree to this arrangement on the basis that the founder would be committing to paying full market value for the shares (as at the time of issue) at a future point in time, with the founder’s return thereby being restricted to future growth.

Provided the shares are acquired for a subscription price equal to their unrestricted value, the acquisition does not give rise to employment tax liabilities (and the subscription agreement can cater for the eventuality of HMRC disagreeing with the shares’ valuation by providing for an automatic uplift in the subscription price to occur in those circumstances).  Assuming a ‘section 431 election’ is entered into within 14 days from acquisition, future increases in the shares’ value will normally be treated as capital subject to CGT rather than employment income.

The arrangement is not entirely free from employment tax liabilities, as the subscription price not paid up is treated similarly to a cheap taxable loan.  This has two consequences:

  • First, to the extent that interest is not charged or is charged at below the HMRC official rate of interest (2 per cent per annum as at the date of this Insight piece, but this may increase in the future), there would be an annual charge to income tax on the benefit of not having to pay sufficient interest (subject to the availability of an applicable relief). Where a charge to income tax arises, there will also be a charge to Class 1A NICs for the employer company.
  • Secondly, if the relevant amount is written off, there will be a charge to employment income tax and NICs on the value written off.

The main risk of this type of arrangement is a commercial one, as in the normal course of events any amount of the subscription price left outstanding will eventually become payable and the value of the shares acquired nil-paid can go down as well as up.  In the event the payment obligation is crystallised at a successful exit, a founder holding nil-paid shares should be able to pay the outstanding amount out of the exit proceeds due to him.

However, if the payment obligation was crystallised by an insolvent liquidation, the subscription price left outstanding would be payable – even if at that point the nil-paid shares are worth less than the amount outstanding. A liquidator normally has no choice but to call in any amounts owed to the company; consequently, getting the outstanding subscription amount written off is not an option in those circumstances.  For those reasons, a founder will often regard the use of nil-paid shares as too risky, especially where the financial situation of the company in question is less than secure.

All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website.  None of the above constitutes legal advice and is not to be relied upon.  Much of the above will no doubt fall out of date and conflict with future law and practice one day.  None of the above should be relied upon.  Always seek your own independent professional advice.

Humphreys Law

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