What you do or don’t get will be written into the shareholders agreement you will sign to receive your shares. It’s in this agreement where all the detail is. I strongly recommend you get your shareholders agreement checked by a legal professional before even thinking of signing it, so you fully understand what you are committing to.
Most shareholder agreements will have different categories of share, e.g. A, B, C, D etc. It’s common practice that you will receive a different category of share to the current owners or investors, so nothing sinister in that. In the shareholders agreement, your category of share, be it A,B,C or D will have detail explaining what you would get in any sale, and how you are paid any percentage of profits, plus additional detail on what parts of the running of the business you have a say on.
It’s perfectly legal to give you say 10% equity in the business and 5% of profit and 0% of the sale value, so check you are actually getting in the contract is what you believe to be correct.
How Is Profit Paid Out?
Profit from a business is paid out in dividends but how is the profit calculated? What is the policy on how much profit is paid out as dividends to the shareholders? And how else can a shareholder or director take money from the business if it’s not taken as a share dividend?
What is the company’s dividend policy? Another misconception is all profits are paid out each year, however this is often not the case. Taking into account cash flow and forthcoming investments, a lot of businesses will retain some of the profit in the business, i.e. not pay out all profit in dividends. Plus there are personal tax and National Insurance levels which any savvy director / shareholder will take into account when making decisions on how much profit to take in dividends, so this can influence how much of the profit it paid out in dividends.
Some owners take a ‘basic salary’ which comes out before profit is calculated, nothing wrong with that, but how much is this basic salary? If the business makes £300,000 profit but the owner has a £250,000 basic salary, you could be getting a percentage of the £50,000 left after the deduction of their basic salary, so if it’s 10%, only £5,000 profit.
How are shareholders’ pension contributions paid? Withdrawals from the business to be paid into a shareholder’s pension reduces the business’ Corporation Tax bill, so is often a smart move. However, would you get the appropriate percentage of shareholder pension payments paid into your pension? E.g. If you own 10% of the business, the owner takes out £100,000 for their pension, do you get £10,000 paid into yours?
Ask your legal advisor to qualify these points and check who makes the decisions on the company’s dividend policy.
What About a Company Sale?
I see far too many situations where owners make big claims that they are building the business to sell for a huge amount and your share could be worth enough to retire on. However, this all too often comes with a shareholder offer that pays zero profit. Recruitment business sales are far less common and harder to achieve than people think. Will a business sale ever happen, despite the best intentions of the owner? You could be hanging on for years for this big pay off that may or may not happen. You can then feel trapped, you’ve hung in there for that long now, you can’t just walk away. There is no reason you can’t ask for a ‘cash in clause’ if you leave, e.g. you can take the share value X years after signing the shareholder agreement. If the owner has a plan to sell in 3 years, asking for a cash in clause after say 5 years, isn’t unreasonable is it?
This is another reason why you need a legal professional, to check the details on any future sale. What if you decide to leave the business, can you take your shares, can you sell your shares, what if they make you redundant or sack you prior to a sale, where do you stand then with your shares? Also is there any provision that states the business must be sold at market value. The owner could theoretically sell the business to a friend or relative for £1, and you get 10p. They then buy it back off said friend or relative for £1 and they then have 100% of the shares back. Apologies if I sound cynical, it’s merely to help you check the detail so you know the deal is as good as your boss says, and to ensure your share values are protected.
If you are being offered the shares on the basis you could form a management buyout at some point, do you get the first option to match any other offer the owner receives? If the business is sold, are you tied in for a period after the sale? If you are, for how long?
If the business is sold, do you have to sell your shares, could the owner sell their shares, but the new owner doesn’t have to buy yours? This area is covered in drag and tag clauses which your legal advisor will be checking for you. I have added a link at the end of this blog to an article explaining drag and tag rights.
You don’t have to be a Director and a shareholder, but if you do get a share of the business, it’s very rare you don’t become a Director in the business.
By becoming a Director, you are partly liable for the running of the business in the eyes of the law, so if there is a large claim made against the business that will include you. In the recruitment industry there is nowhere near as much risk in becoming a Director as say the construction sector. If there is an unlawful death onsite where lack of health and safety is to blame, the Directors can be charged with corporate manslaughter. I do know a number of business people who have shares in companies but refused to become Directors to avoid any legal obligations. The risk that comes with being a Director in the recruitment industry is a lot lower, however if your boss plays fast and loose with cash flow and tax bills, this something you may want to consider.
However, the upside of being a Director is that you do have a legal right to have some say in how the company is run so it can offer you some protection. How much say you will have and what rights you have will be in your Directors and Shareholder contracts, they could in real terms be restricted to very little.
In your Directors’ contracts you will have a notice period and restrictive covenants. Directors’ contracts are an awful lot harder to challenge in court than an employment contract if things go sour. Also, you can have a much longer restrictive covenant, up to 2 years, which is generally rock solid, unlike employment restrictive covenants which can only include 6 months and are a lot easier to contest.
Often this lengthy restrictive covenant is the ‘win’ the owner is getting for giving you shares. It’s a very smart move to tie in your best and most important employees, just make sure you feel the deal you are being offered is worth this tie in.
Tax on Receiving Shares
If the business is of any value you can’t just be given shares and not taxed on that value, as you are receiving a taxable benefit. Tax regulations are ever changing so I won’t give you exact details, so as not to mislead. However just check if you are being given shares if the owner is paying the tax on the value of the shares you are being given or are you liable for it. The owner may tell you they have told the accountant there is no market value for the shares, but if there is a tax inspection would an inspector see this differently and you’re landed with a big tax bill.
Your legal advisor should be able to help advise on this and will often recommend an independent accountant to advise if the business does have a market value.
Being given shares in a business can be a great deal for you, if they are structured right. I have heard lots of positive stories of employees receiving the recognition for their value in the business and doing very well out of it.
However, I have heard just as many stories of shares being of no, or little value, and simply tying people into a contract with long restrictive covenants, leaving them feeling trapped.
Get good advice, and if you want a simple commercial overview of your offer you can always contact me. Often the offer of shares does bring to the surface the question “if I did it myself, would my own business be worth more than this small percentage?” Sometimes yes, sometimes no, but I will give you honest advice.
Further information on drag and tag rights can be found here.
Written by Rhys Jones Managing Director – Davidson Gray