Growth shares: what are they and how do they work?

For growing businesses, attracting and retaining key people can be difficult, especially when competing with larger companies that can offer higher salaries and more established benefits packages.

Growth shares can provide an alternative way to incentivise key employees and align their interests with those of existing shareholders. They allow individuals to participate in future increases in the value of a company, without necessarily giving them a share of the value existing shareholders have already created.

They can be particularly useful for private companies planning for growth or a future sale, as well as businesses that cannot use, or do not want to rely solely on, a tax-advantaged share option scheme.

However, growth shares need to be structured carefully. At the outset, you need to consider the company's valuation, the hurdle above which the shares participate, the rights attached to them, and what happens when an employee leaves or the business is sold.

If you are considering growth shares for your business, contact our corporate solicitors to discuss how they could work for you.

What are growth shares?

Growth shares are a separate class of shares designed to allow their holders to participate in future growth in the value of a company.

Unlike ordinary shares, they will generally only participate economically once the value of the company exceeds an agreed threshold, commonly known as a hurdle.

The effect is that the value already created by existing shareholders can be protected, while employees or other participants have an opportunity to benefit from value created after the growth shares are issued.

Growth shares can have limited rights compared with ordinary shares. Depending on how they are structured, they may have restricted or no voting or dividend rights, with their principal economic value arising when the company exceeds the hurdle, commonly on a sale or other exit.

How do growth shares work?

A company will usually create a new class of shares with specific rights set out in its articles of association.

A hurdle is then established by reference to the value of the company when the growth shares are issued. The growth shareholders typically participate only in value above that hurdle, although arrangements can be structured in different ways.

For example, assume a company is worth £5 million when growth shares are introduced. 

The rights attached to those shares could provide that the existing shareholders are entitled to the first £5 million of value on a future sale, with value above that amount shared between the ordinary and growth shareholders in agreed proportions.

If the company were subsequently sold for £8 million, the growth shareholders would therefore participate in the additional £3 million of value, rather than receiving a proportion of the £5 million of value that existed when their shares were acquired.

In practice, arrangements can be more sophisticated. Different participants may have different hurdles, vesting arrangements or entitlements, so the company's articles and associated agreements need to set out precisely how proceeds will be distributed.

Why do companies use growth shares?

Growth shares are principally used to incentivise individuals expected to contribute to the future growth of a business.

For existing shareholders, they can provide a way to offer meaningful equity participation without simply transferring part of the company's existing value to new shareholders. For employees, they provide an opportunity to participate directly in the future success of the business.

Companies may therefore consider growth shares where they want to:

• Incentivise and retain key employees.
• Recruit senior or strategically important individuals.
• Align management with the objectives of existing shareholders.
• Reward employees for increasing the future value of the business.
• Provide employees with an opportunity to participate in a future sale or exit.
• Protect value already created by existing shareholders.
• Introduce an equity incentive where another share scheme is unavailable or unsuitable.

Growth shares may also form part of a wider incentive structure rather than being used as an alternative to every other form of employee incentive.

Can growth shares be used for family succession planning?

Growth shares are often associated with employee incentive arrangements, but they can also be used as part of wider family succession and wealth planning strategies.

Business owners frequently wish to pass future growth in a company to the next generation while retaining the value they have already created. Growth shares can help achieve this by allowing family members to participate only in future increases in value above an agreed hurdle.

For example, where a company is worth £5 million today, growth shares might be issued to adult children with a hurdle set at that value. The existing shareholders retain the current value of the business, while future growth above £5 million accrues partly or wholly to the holders of the growth shares.

This approach can allow future value to pass to the next generation without requiring the existing shareholders to surrender the full economic benefit of the value already built up in the company.

Growth shares are often considered alongside other succession planning structures, including family investment companies, freezer share arrangements and trusts. The most appropriate structure will depend on the family's objectives, the nature of the business and the intended timescale for succession.

Because growth shares can have significant inheritance tax, capital gains tax and income tax implications, specialist legal and tax advice should always be obtained before implementation.

What is a growth share hurdle?

The hurdle is one of the defining features of a growth share arrangement. It establishes the value above which the growth shares begin to participate economically.

The hurdle might be based on the current equity value of the company and may include an additional premium, depending on the commercial objectives and valuation advice received.

Setting it appropriately is important for both commercial and tax reasons. If the hurdle is too low, existing shareholders may give away more of the company's existing value than intended. If it is too high, the incentive may have little realistic value to the employee.

Companies may also issue growth shares to different employees at different times. Where the company has increased in value between awards, later participants may need a different hurdle.

How are growth shares valued?

Valuation is one of the most important aspects of introducing growth shares.

Although a growth share may have little immediate economic entitlement because of its attached hurdle, that does not necessarily mean it has no market value. The prospect that the company will increase in value can itself give the share value, sometimes referred to as its "hope value". Valuation frequently requires specialist advice because option-pricing and probability-based methodologies may need to be used when determining the value of growth shares.

A professional valuation will therefore generally consider the current value of the company, the hurdle, the rights and restrictions attached to the shares and their prospects of ultimately participating in future value.

This is particularly important where growth shares are acquired by employees. If an employee acquires employment-related shares for less than their market value, tax consequences can arise.

Companies should therefore obtain appropriate valuation and tax advice when establishing the hurdle and determining the price payable for the shares. A contemporaneous valuation can also be important if HMRC subsequently queries the value attributed to them. Unlike EMI options, HMRC will not generally agree the valuation of growth shares in advance, although contemporaneous professional valuation evidence can be important if the valuation is later challenged.

What are the advantages of growth shares?

Growth shares can allow existing shareholders to preserve the value they have already created while giving employees meaningful exposure to future growth.

Their terms can also be tailored to the objectives of the business and the individuals participating.

Potential advantages include:

• Protecting existing shareholder value below the agreed hurdle.
• Creating a direct link between employee reward and future business growth.
• Helping recruit and retain important employees.
• Providing flexibility over voting, dividend and economic rights.
• Allowing vesting and leaver provisions to reflect the company's requirements.
• Giving employees genuine equity ownership rather than simply a cash bonus.

They can also be useful where a company does not qualify for a tax-advantaged option arrangement or where another incentive structure does not meet its commercial requirements.

What are the disadvantages and risks of growth shares?

Growth shares are not necessarily the right solution for every business.

Creating an additional class of shares adds complexity to a company's share capital and constitutional documents. The business also needs to establish an appropriate valuation and hurdle and determine how growth shareholders participate in future proceeds.

Potential issues include:

• The cost and complexity of obtaining appropriate valuation, legal and tax advice.
• The possibility that the shares never exceed their hurdle and produce no return.
• The need to manage employee shareholders who subsequently leave the business.
• Additional complexity when raising investment or selling the company.
• Potential tax liabilities if the shares are acquired for less than their market value.
• The need to ensure the arrangements work alongside existing shareholders' agreements and investor rights.

Participants become shareholders when they acquire their shares, so shareholder rights, leaver arrangements and future transactions need to be considered from the outset.

What happens to growth shares if an employee leaves?

Leaver provisions should be considered when the growth shares are created rather than when an employee leaves.

Because the employee is normally already a shareholder, their employment ending does not automatically mean their shares disappear.

The company's articles and/or subscription arrangements can therefore govern what happens to the shares when employment ends. These might include vesting provisions and compulsory transfer or purchase arrangements, with different consequences depending on the circumstances in which the employee leaves.

For example, an arrangement might distinguish between an employee leaving in agreed circumstances and someone dismissed for misconduct or breaching restrictive covenants.

The documentation should clearly set out what happens to vested and unvested shares, whether they must be transferred, and how any purchase price is calculated. Without appropriate provisions, a former employee could potentially remain a shareholder after leaving the business.

How are growth shares taxed?

The tax treatment of growth shares depends on their structure and the circumstances in which they are acquired.

Where an employee acquires shares because of their employment, the employment-related securities rules need to be considered.

 Where properly structured, future increases in value may be taxed under the capital gains tax regime rather than as employment income, although the position will depend on the shares issued, any restrictions applying to them, the amount paid and the employee’s individual circumstances.

However, if shares are acquired for less than their market value, an income tax charge may arise on the difference. PAYE and National Insurance contributions may also need to be considered in some circumstances.

Growth shares will also commonly contain restrictions, such as vesting or leaver provisions.  It is common for employee growth share arrangements to involve restricted securities. Careful consideration should therefore be given to whether a joint election under section 431 ITEPA 2003 should be entered into.

The interaction between valuation, the amount paid for the shares, their restrictions and the employment-related securities rules can be complex, so specialist tax advice should be obtained alongside legal advice before growth shares are issued.

Growth shares vs EMI share options

Growth shares and Enterprise Management Incentive (EMI) options can both be used to incentivise employees, but they operate differently.

With growth shares, the employee normally acquires shares at the outset. Their ability to benefit from those shares is governed by the hurdle and the rights and restrictions attached to the relevant share class.

Under an EMI arrangement, the employee is granted an option to acquire shares in the future, subject to the terms of the option and the statutory EMI requirements.

EMI can offer significant tax advantages for qualifying companies and employees, but it will not be available or appropriate in every situation. Growth shares can provide an alternative where EMI is unavailable or does not achieve the company's commercial objectives. For more detail, read our guide to how EMI share option schemes work.

The two structures are not necessarily mutually exclusive. Growth shares can potentially also be used alongside an EMI arrangement, depending on the circumstances and objectives of the business.

The right approach depends on factors including the company's activities, ownership structure, valuation, participating employees, future plans, and intended exit strategy.

Where a company qualifies for EMI, EMI options are often considered alongside growth shares because of the significant tax advantages they can offer.

Growth shares vs alphabet shares and freezer shares

Business owners considering succession planning or employee participation will often encounter growth shares, alphabet shares and freezer share arrangements. Although they can be used together, they serve different purposes.

Growth shares are designed to participate primarily in future increases in value above a specified hurdle. They are commonly used to incentivise employees or transfer future growth to family members while protecting existing shareholder value.

Alphabet shares are different classes of ordinary shares, often labelled A shares, B shares, C shares and so on. They can provide flexibility over dividend payments and ownership arrangements but do not necessarily restrict shareholders to future growth only.

Freezer share arrangements are designed to "freeze" the current value of an owner's interest while allowing future growth to accrue to another class of shares. Growth shares are frequently used as part of a freezer arrangement where business owners wish to transfer future value to the next generation.

The most appropriate structure will depend on the company's objectives. In some cases, a straightforward alphabet share structure may be sufficient. In others, a carefully structured growth share arrangement may provide a more effective solution. Businesses should obtain legal and tax advice before implementing any restructuring of their share capital.

What legal documents are needed to issue growth shares?

Introducing growth shares usually requires more than simply issuing additional shares.

The legal work may include:

• Reviewing the company’s existing articles of association, shareholders’ agreement and investment documents.
• Creating a new class of shares and defining the rights attached to them.
• Amending the articles of association where required.
• Establishing the hurdle and determining how future growth will be shared.
• Preparing subscription or share acquisition documentation.
• Introducing appropriate vesting, leaver and compulsory transfer provisions.
• Obtaining board and shareholder approvals.
• Considering investor consent requirements and pre-emption rights.
• Updating statutory registers and making the necessary Companies House filings.
• Ensuring the arrangements work effectively on a future sale, investment round or other exit event.

Existing investment documents should also be reviewed, as investor consent or other approvals may be required before the company's share capital or articles can be changed.

What happens to growth shares when a company is sold?

A future sale is often central to the commercial rationale for growth shares.

The documents need to establish how growth shareholders participate in sale proceeds once the hurdle has been exceeded and ensure the shares work alongside the company's wider exit provisions.

For example, existing drag-along provisions may need to cover growth shareholders so that a buyer can acquire 100% of the company without individual minority shareholders preventing or delaying the transaction.

The company may also consider mechanisms that allow necessary documents to be executed on behalf of participating shareholders when an exit takes place.

Getting these provisions right when the growth shares are introduced can avoid complications when shareholders are trying to complete a future sale.

Are growth shares right for your business?

Growth shares can be an effective way to give key employees a meaningful stake in future business growth while protecting value already created by existing shareholders.

The company needs to decide who should participate, how much future value it is prepared to share, where the hurdle should be set, what rights participants should receive and what happens if an employee leaves.

Those decisions need to be reflected consistently across the company's articles, shareholder arrangements and growth share documentation, with appropriate valuation and tax advice obtained from the outset.

Tax treatment depends on individual circumstances and legislation may change. Specific tax advice should always be obtained before implementing a growth share arrangement.

Speak to our corporate solicitors about growth shares

Our corporate solicitors advise companies, shareholders, and management teams on growth shares, employee incentive arrangements, shareholder agreements, and broader corporate structuring.

Dylan Leet, partner and corporate solicitor, said: 

“Growth shares can work really well, but the important thing is getting the structure right from the start. You need to be clear about what you’re trying to achieve, who you want to incentivise, and how much future business growth you’re prepared to share. Getting those decisions right at the outset can save a lot of difficulty later on.”

If you are considering introducing growth shares, reviewing an existing incentive arrangement or preparing your business for future investment or sale, contact our corporate solicitors to discuss the appropriate structure for your business.