Simplifying Leaver Provisions?

by Orrick, Herrington & Sutcliffe LLP
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Introduction
In response to the Nuttall Review of Employee Ownership, the Government has introduced the Companies Act 2006 (Amendment of Part 18) Regulations 2013 (the Regulations) which entered into force on 30 April 2013.

This alert outlines the main changes introduced by the Regulations and assesses their potential implications, which will be of particular interest to emerging companies as it is now easier to buy back shares from employees.

Leaver Provisions
A common feature of any emerging company is that the entrepreneurs and/or the employees will likely be subject to some form of leaver provisions such as:

  • converting some or all of the leaver's shares into worthless deferred shares; or
  • requiring the leaver to transfer some or all of their shares to the company at a set price.

Both options have their limitations. The conversion mechanic is an all or nothing provision and is probably most useful in scenarios where a "bad leaver" is required to forgo some or all of their shares. The compulsory transfer provision is more flexible as a company can buy back a leaver's shares at fair market value, but historically has been of limited use as it is difficult for private companies (and almost impossible for early stage pre-revenue companies) to enforce as the legal formalities regarding purchasing shares are complicated and expensive.

What will the Regulations change?
The Regulations make four key changes to the Companies Act 2006 (the Companies Act), namely to:

(i) remove the requirement for a special resolution for off-market share buybacks of shares acquired through employee share schemes;

(ii) permit use of a single ordinary resolution to authorise multiple share buyback contracts (where the shares are acquired through an employee share scheme);

(iii) introduce flexibility to the timing and financing of payments for share buybacks; and

(iv) extend the power to hold shares in treasury to all companies limited by shares.

Financing Buybacks
The most important amendment relates to extending the methods for financing share buybacks. Previously the Companies Act required share buybacks to be financed using distributable profits, the proceeds of a fresh issue of shares made for the purpose of financing the purchase, or a payment out of capital (the procedure for which required a director's statutory declaration and auditor's report, special resolution and public notice). Many emerging companies are pre-revenue and therefore unlikely to have distributable reserves and it may be difficult to time a fresh issue of new shares. The buyback of shares or the legal costs involved in effecting a buyback are also often disproportionately high.

The Regulations introduce the ability for a private company to buy back shares using cash, without having distributable reserves subject to:

  • having the requisite authority in its articles of association or from a special resolution; and
  • a limit in each financial year of the lower of £15,000 and 5% of the company's share capital.

The requirements for buying employee shares back out of capital pursuant to an employee share scheme have been simplified by removing the requirement for an auditors report which has been replaced by a directors solvency statement. However, the payment out of capital must still be made between five and seven weeks after the date on which the shares are surrendered.

Treasury shares
The Regulations extend the power to hold shares in treasury to both private and unlisted public companies (as well as listed companies). Accordingly, shares repurchased by a private or unlisted public company will no longer be subject to automatic cancellation but can be held as treasury shares. The company will be the registered holder of the treasury shares but will not be entitled to exercise any right in relation to those shares e.g. to receive a dividend or to attend and vote at a general meeting of the company. This may be particularly useful for more mature companies or later stage companies.

Tax
For shareholders the proceeds of sale on a buyback are likely to include, under normal rules, an element of capital and an element of income. Where the original issue price of the relevant shares was low the majority of sales proceeds are likely to be taxed as income. The difference between sale proceeds and the price paid for the shares by the shareholder (whether or not different from the issue price) should be considered to determine whether a capital gain or loss has arisen also. In certain circumstances, particularly where it is necessary for the benefit of the company to remove a shareholder, it may be possible to obtain capital gains tax treatment on the whole proceeds of the buyback. In all circumstances the employment related securities rules (which can apply to deem the acquisition or disposal of shares by employees to give rise to employment income receipts) should be carefully considered.

For the company the buyback of its own shares is likely to give rise to a stamp duty or stamp duty reserve tax liability. For tax purposes shares purchased into treasury are treated as if they have been cancelled. Shares subsequently sold out of treasury are treated as if they are part of a fresh issue and corporation tax relief may be available under chapter 2 of part 12 of the Corporation Tax Act 2009 if those shares are issued by the company to an employee or other person in connection with the employee's employment by the company.

Implications of the Regulations
Whilst the extension of the methods for financing share buybacks is welcomed it is expected that the impact will be minimal and will most likely be useful in the context of founder bad leavers. In the UK most optionholders do not exercise their options until an exit and it is rare to have emerging companies with large employee shareholder bases.

Companies with employee share schemes will need to amend (or adopt new) articles of association to take advantage of the Regulations to: (i) authorise the buyback by ordinary resolution; (ii) fund the purchase out of cash; and (iii) pay for the shares in instalments.

About Orrick
Orrick is the leading global law firm for technology and high growth companies. Our specialist teams are based in 25 offices throughout the world, including Silicon Valley, Berlin, London, Paris, Munich, Beijing, New York and Shanghai. Throughout the life cycle of high growth companies, we advise on financing transactions from start-up funding through to VC investments and exits as well as commercial transactions, intellectual property and data privacy issues.

Additional Information
If you would like to discuss any aspect of this alert, or require further information on the matters referred to, please contact:

Corporate practice
Jinal Shah on +44 20 7862 4613, Hilary Winter on +44 20 7862 4605, Giles Hawkins on +44 20 7862 4780 or Alice Edwards on +44 20 7862 4716.

Tax practice
Nick Thornton on +44 20 7862 4612 or Will Gay on +44 20 7862 4762.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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