Payne Hicks Beach

Payne Hicks Beach

07 December 2012

Employee Shares: a Poisoned Chalice?

Company Commercial partner Max Hudson and Sophia Killingbeck examine the Government's proposals on employee shares.

Employee Shares: a Poisoned Chalice?

"And there is nothing that wastes so rapidly as liberality, for even as you exercise it, you lose the power to do so, and so become either poor or despised, or else, in avoiding poverty, rapacious and hated." Machiavelli

As part of the Government's push towards more responsible capitalism, it has passed the Growth and Infrastructure Bill, Royal Assent was given on April 25. The Act creates a new employment status, the 'employee shareholder'. The idea is to align the interests of employees and the businesses they work for by giving workers a greater (financial and personal) stake in their employer. The theory as promulgated is that this will encourage lower absenteeism, a happier workforce and therefore less staff turnover.

The Government are seeking to put this into practice by implementing measures whereby workers can give up certain employment rights for shares in their employer. Employees will be given £2,000 and upwards of shares, and any growth in value of these shares will be exempt from capital gains tax.

In turn they will waive their statutory rights to (non-automatic) unfair dismissal, redundancy, the right to request flexible working and time off for training; women will also be required to provide sixteen weeks' notice of a firm date of return from maternity leave, instead of the usual eight.

Employees will be giving up rights for what will be minority shares. As is well known, minority shares are only worth what someone is willing to pay for them. Accordingly, regardless of the financial strength of the company, these shares will be of no practicable capital value if there is no one willing to take them on. Employer companies will in turn have a multitude of minority shareholders on their books, which could have a negative impact on corporate governance, especially if these minority shareholder employees become disgruntled.

The Government seems to have attempted to confront this issue to a certain extent by putting forward amendments to the Companies Act 2006 (the 'Act'), with the intended effect of facilitating buy-back of such shareholdings by employers. For example, the provisions of s. 724 of the Act are to be extended to allow unlisted shares that are purchased by a private limited company to be held in treasury, and an exception to s. 691(2) is to be introduced to allow a private company to pay for its shares by instalments.

However, amendments incorporated into the legislation will be of no avail where disgruntled employee shareholders neither want to leave their employment nor sell their shares back to their employer, but without some form of call option held by the employer this cannot be imposed, and usually has a time limit. The current state of the law tends towards more regulation and obligations on directors; a great deal of de-regulation will be required in order to make the new statute workable in practice. It does not seem that the Government has really grasped quite the extent of de-regulation required.

The Deputy Prime Minister extolled the virtues of creating a 'John Lewis Economy', advancing the benefits of increased resilience and employee and owner accountability. However, what Mr Clegg failed to acknowledge in many ways unique is the way in which the John Lewis Partnership was established - how John Spedan Lewis handed over the control and ownership of John Lewis to its employees in two trust settlements (in 1929 and 1950).

This is a significant detail to overlook; the partnership had the ultimate benefit of the plentiful capital supplied at its foundation by a radical, philanthropic millionaire - and the current successful running of its ownership structure is down to 80 years' hard work and fine-tuning.

Consequently, John Lewis is not a realistic case study to work from. It is an unrealistic benchmark when we consider the grim reality of everyday businesses which rarely have the fortune of not requiring external funding.

The dilution of workers' rights was not recommended by the Nuttall Review. The giving up of rights for shares is designed supposedly to increase flexibility and reduce the financial burden on employers of potential employment litigation costs. However, claims for discrimination and whistleblowing are where the greatest financial burden lies in relation to such litigation, as employers are open to liability for unlimited - rather than capped - compensation. As a result, this part of the proposal seems particularly ill-suited to meeting its aims. On this point, it is instructive that even the Employee Ownership Association has strongly criticised this aspect of the legislation, arguing that the point of employee ownership is to enhance workers' rights, not weaken them. The viewpoint of the private sector was clearly articulated in the Consultation put out by the Government which confirmed the overwhelmingly negative feedback by respondents, with only 3 of 184 respondents saying that they would actually take up the scheme, and fewer than 5 of 209 respondents thinking that the scheme was a good idea.

Issues: employers

The Government has stated that both established companies and new start-ups can choose to offer only this new type of 'employee-owner' contract for new hires.

This contract will prove to be an extensive document, covering the employment relationship as well as offer of shares, rights attaching to those shares, call and put options, drag and tag along clauses and other shareholder arrangements.

Offer of shares

The offer of shares to employee-shareholders, although unlikely to trigger a prospectus requirement, must be carefully drafted so as to avoid additional potentially huge costs of putting together a prospectus. As such, it must be clear in the contract that the offers to employees are not offers to the public (per Part VI FSMA 2000). Furthermore, despite not needing to comply with the strict prospectus rules in relation to an offer to the public, the employer will still liable for any misrepresentations, so must ensure that the offer of shares is precisely and meticulously drafted.

For established companies, it will also be necessary to consider any current restrictions on share issue; is there a shareholders agreement in place? Similarly, with new start-ups, how will the relationship between employees-owners be governed?


It has been acknowledged that there will need to be in place mechanisms by which to buy back shares owned by employees who are leaving or have left the company, in order to re-distribute them to new starters. In addition to the proposed statutory changes facilitating buy-back by employers (see above), the new employee-owner contracts will have to include call and put options, by which employers can secure and dictate buy-back of shares. Otherwise, the employer company risks becoming at least part-owned by ex-employees (possibly hostile ones).

As is well known, call options can be used to incentivise so-called 'good leavers'. However, shares prescribed in accordance therewith will have to have a value assigned to them. If this were the market value, valuation costs could potentially be onerous, especially where there is a large workforce and high staff turnover.

It must also be noted that FSMA as it stands effectively prohibits employers themselves from giving employees any advice or recommendation in relation to shares. The general prohibition and financial promotion prohibition both contain exclusions/exemptions in relation to employee share schemes; these do not apply, however, where shares are also offered to non-employees. As such, employers must be very careful not to contravene the FSMA regulations unintentionally.


Dependent on the capital requirements of the company, employee shares could serve as a hindrance to funding, disparaging external equity investors from investing in the company. This is particularly the case given the preferential status of employees on insolvency (see below).

Employment Issues

New employees will not have the right to claim ‘ordinary' unfair dismissal or a statutory redundancy payment until they have been employed for more than two years. As a result, it is disputable whether employers would actually gain anything in this regard by giving share ownership at the beginning of employment. Furthermore, whilst employees may be willing to sign away their rights to request flexible working, this will not necessarily prevent them from running an alternative case based on discrimination in the event that a request to work flexibly is refused.

Whistleblowing and discrimination claims will not be waived by the new arrangements; as such, it is questionable whether dismissing employees will in fact be made any easier by the proposed measures.

Issues: employees

The employee-owner contract will have to provide employees with assurances regarding their rights to dividends, pre-emption rights and capital protection.


At John Lewis, partners are provided with a dividend once a year as a 'bonus'. This is promoted as a great incentive during the busy Christmas period.

However, John Lewis had an annual turnover of £8.73 billion last financial year. Yearly dividends will unlikely be so forthcoming with new start-ups, at least not immediately, given that very few new businesses will want to commit so early to paying dividends out of income. Any distributable profits at the beginning of a company's life would more likely be better reinvested into the new business.

As a result, in such cases where the benefit of dividends is deferred for some time, it is likely that this additional income will fail to serve as an incentive to employee-owners.

Pre-emption rights

Will pre-emption rights need to be considered every time a new employee owner is taken on?

If others sell, can you too?

Capital Protection

It is an extreme example, but employees obviously did not benefit from the Enron employee share option scheme. Employee-owner contracts will have to provide for capital protection.

Voting rights: too many cooks?

John Lewis management have recognised that running a business under the employee-ownership model is not the easy option. The written constitution of the John Lewis Partnership puts the happiness of its members as its avowed purpose, giving every partner a 'voice' and voting rights. However, what is good for individuals is not always good for business; corporate democracy may mean more accountability, but it can also lead to unrelenting and irremediable discord between executives and partners.

Employee-owners are not passive and distant shareholders; they are present and active for the day-to-day running of the business they co-own. This implies lengthy decision-making processes on both director and shareholder level, adding a layer of complexity and frustration potentially to even the most trivial matters.


The Government has exalted the benefit of employee shares being capital gains tax-exempt. However, given that the initial value of employee shares will be between £2,000 and £50,000, any gain on the shares will have to be exceptional not to be covered anyway by the Annual Exemption.

This is especially pertinent when consideration is given to the fact that these employee-owners would be forgoing their rights to claim unfair dismissal; this in practice means that they may be giving up a potential, tax-free £30,000 - the first £30,000 of any compensation award for unfair dismissal being exempt of tax. Consequently, when balancing out the potential benefits lost and burdens gained with the alleged capital gains tax advantages, it would be unusual for an employee-owner to come out on top.

The Chancellor's packaging of this scheme as beneficial for tax may be questionable; it will in fact be more onerous in tax terms for all but those with shares the capital value of which has grown substantially.

The Office for Budget Responsibility raised concerns, stating that the tax break on these categories of shares could cost the taxpayer £1 billion by the end of the forecast horizon, with £250 million potentially down to tax avoidance.

Accordingly, the director of the Institute for Fiscal Studies has remarked that the Government, "just as it is berating those who have picked up the tax sweeties currently lying around... is preparing to put another billion-pound lollipop on the table."


If the employer company gets into financial difficulty, employees will be better placed than ordinary shareholders; some employee rights will be classified as preferential debts, others unsecured, while still further rights will be covered to some extent by the National Insurance Fund. This could well act as a deterrent for external investors (debt and equity), whose rights would not be as well protected.

The legislative process

The House of Lords rejected the scheme twice, latterly by a margin of 69 votes. Despite clear disapproval from the Lords and a very low level of support during consultation, the Government has pressed ahead, albeit with a few concessions.

These included;

  • A requirement that employee share-ownership schemes involve any employees receiving independent legal advice and employers will be required to pay for this advice.
  • No employee can be forced to accept such arrangements.
  • Companies will also need to provide written information to help clarify the value of the shares being offered.

As a result, Conservative and crossbench peers dropped their resistance to the controversial plan allowing it to pass by 275 votes to 168 in the House of Lords on 24 April.


Despite 92 per cent of the respondents to the Government consultation viewing the plans in a negative or mixed way; the bill was passed after a second reading in the House of Lords.

For employers, there is the issue of minority shareholders possibly frustrating the business, as well the risk of more esoteric claims in the discrimination field.

For employees, there is the risk of giving up a certain right in exchange for an unquantifiable and uncertain 'benefit', with little - if any - tax advantage.

The reception and likely take-up of the opportunities created by new legislation remain very unclear. Payne Hicks Beach will be monitoring developments in this area.

28 May 2013

Max Hudson is a partner and Sophia Killingbeck is a trainee solicitor, in the Company Commercial Department at Payne Hicks Beach.


10 New Square, Lincoln's Inn, London WC2A 3QG

DX 40 London/Chancery Lane
Tel: 020 7465 4300 Fax: 020 7465 4400 

This publication is not intended to provide a comprehensive statement of the law and does not constitute legal advice and should not be considered as such. It is intended to highlight some issues current at the date of its preparation. Specific advice should always be taken in order to take account of individual circumstances and no person reading this article is regarded as a client of this firm in respect of any of its contents.

The firm is authorised and regulated by the Solicitors Regulation Authority: SRA Number 00059098

© 2013 Payne Hicks Beach

10 New Square, Lincoln's Inn, London WC2A 3QG

DX 40 London/Chancery Lane
Tel: 020 7465 4300 Fax: 020 7465 4400

This publication is not intended to provide a comprehensive statement of the law and does not constitute legal advice and should not be considered as such. It is intended to highlight some issues current at the date of its preparation. Specific advice should always be taken in order to take account of individual circumstances and no person reading this article is regarded as a client of this firm in respect of any of its contents.

The firm is authorised and regulated by the Solicitors Regulation Authority: SRA Number 00059098

© 2017 Payne Hicks Beach


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