Attracting, keeping and rewarding key staff is becoming increasingly cutthroat for small businesses as the UK economy picks up steam.

Unemployment is at a seven year low, the number of people in work has hit a new record high, and average pay has risen since last year, according to the latest official figures.

But it doesn’t stop there. Regular pay increases have outstripped inflation for seven months in succession.

All this has meant the jobs market is far more competitive for small and medium sized enterprises. Employers are feeling the squeeze and are having to box clever to hang on to their top performers.

The three Rs

There’s now more recognition amongst business owners that ‘the three Rs” (recruiting, rewarding and retaining the best staff) are vital to improving their chances of success.

One highly tax efficient – yet often overlooked – way of doing this is to use employee share incentives. They can be targeted at a particular group, or offered to all employees, so that a company can motivate key employees to identify with the firm’s goals, and hopefully work harder and better.

Essentially employees can be rewarded with cash bonuses, shares or options.

Cash bonuses are simple to administer and can be linked to specific targets for particular employees. The disadvantage is that they are not tax efficient.

Two of the HMRC-approved share schemes, which are tax efficient, are generally unattractive to SMEs as they have to be made available to all employees.

Fortunately there are other alternatives such as options which can be focused on incentivising and rewarding key management.

EMI Options

Enterprise Management Incentive options are flexible, generous and efficient. The key features include the following:-

• a qualifying employee can hold options over shares with a market value (measured when the option is granted) of up to £250,000
• no tax liability arises when the option is granted
• the exercise price (i.e. the amount payable per share when the option is exercised) can be set at any amount, although a tax liability will arise when the option is exercised if this is less than market value at the date of grant
• increases in the market value from the date of grant may qualify for capital gains tax Entrepreneurs’ Relief so that they are taxed at an effective rate of 10%
• the employing company can normally claim a corporation tax deduction equal to the difference between the market value of the shares at the date of exercise and the exercise price.

As an incentive, the option agreement can include objective performance criteria which have to be met before the option can be exercised.  The agreement can also provide that the option can be exercised only on an exit (for example if the business is bought out), and a minimum exit value can be specified.  This not only avoids the need to deal with minority shareholdings it is also a very effective way of tying the individual to the business.

The issue of the business owner’s equity being diluted is mitigated by looking through a long lens. Surely the goal is to keep good staff who will work hard, be more productive and increase the firm’s profits. By giving away some equity to their key staff, the business owner might reduce their stake in proportionate terms, but will still have a smaller share of a much larger business.

This can be complicated, so it is prudent that you seek professional advice before granting options or giving shares to your employees and directors, or altering the rights attaching to shares that they have already received.

Also see: The benefits of EMI Option Schemes – How does your business win?