Helping your clients through tougher times
As a trusted professional adviser, a number of your clients may be asking you for practical, workable advice on how to hold their business together through challenging times.
 
Here is one approach which you should have in your toolbox. It won't help any company whose problems are terminal, but for many essentially strong businesses needing help in managing cash flow through a period of reduced revenues, it could bring substantial benefits. We have already been asked to structure an arrangement of this kind as a key element in one company's rescue package, and in current market conditions we expect it may feature in several more.
 
It enables a company to reduce the size of monthly payroll without necessarily making employees redundant, and so may be of particular value to companies:

• in which employee costs form a high proportion of overhead and/or
• which wish to hold on to their talented people, the better to take advantage of improving market conditions in the future

 
How does it work?
In essence, the company' s employees agree their salary will reduce by a fixed amount (perhaps for a finite period); the company agrees to allocate equity shares, or an interest in shares, the present value of which reflects the value of salary foregone. In many cases, statutory income tax breaks for employee share schemes can help make this a very attractive package, employees potentially paying tax on any eventual reward at between 0% and 18%.
 
Example: Darling Hank Limited
 
Objective: To reduce payroll by 20% for one year, enabling the company to remain cash flow positive. It doesn't wish to make any staff redundant.
 
How it might be achieved: Employees are asked agree to such a reduction and be awarded shares to the value of £120,000 (20% of current annual payroll).
 
By using a Revenue-approved Share Incentive Plan (SIP) the shares are income tax and NI free, so employees are exchanging gross cash pay of £120,000 (circa. £71,000 net if employees are higher rate taxpayers) for net equity pay of £120,000. The company also saves a further 12.8% employer NI (circa. £15,300).
 
What happens next:
Scenario 1: trading conditions improve in subsequent years. After five years, the shares have grown in value by 25% to £150,000. Employees sell them to the company's founder shareholders. Having agreed in 2008 to relinquish £71,000 net of tax, their recompense is to receive a tax free sum which is more than double that. No CGT on the gain in value.
 
Scenario 2: trading conditions continue to deteriorate. After five years, the shares have fallen in value by 35% and are now worth £78,000. This is still greater than the amount of net salary foregone in 2008.
 
Scenario 3: no significant change. After five years, the shares are still worth in the region of £120,000. Employees have a tax free shareholding worth £49,000 more than the £71,000 net amount they forewent in 2008.
 
(Some conditions are attached in creating a SIP, of which a key one is that each employee must normally retain the shares for at least five years. They may sell earlier if they wish but they will then have to pay income tax and NI after all. Whatever the date on which they sell, any growth in value of their shares until sale is tax free.)
 
All of the above figures would naturally be different for basic rate taxpayers.
 
Testing it to destruction
Here are some questions which any sensible company would ask:
 
How do we afford to buy back the shares? The idea is that this enables a deferral of reward, swapping a taxable cash salary today for equity which is intended to be turned into cash tomorrow. It would work best in companies which were confident that, longer term, they would be able finance the repurchase of shares from employees. If share value grew significantly, it might be necessary to consider agreeing to purchase a minimum number of shares back from employees (say, shares to the value of the gross salary originally relinquished), with the remaining shares being repurchased over a longer period.
 
What are shares in the company worth? This will be an important factor in striking a fair deal with employees. It is beyond the scope of this note to consider valuation methods, whether minority discounts should apply and other issues.
 
What if a SIP isn't available? Although the majority of owner-managed UK companies are likely to qualify for setting up a SIP it may not always be available, the five year holding period may be too long or its "all-employee" nature may render it unsuitable. Other tax-advantaged share schemes may be available in which only selected employees would be involved and/or which require no minimum share holding period. Alternatively, a share scheme without tax breaks could be an effective strategy - although it might be necessary to allocate employees shares of a greater current value to make up for the lack of tax breaks.
 
What if the employees feel ordinary shares are too risky? There is no avoiding that there is risk for employees. If they simply won't accept exchanging the certainty of cash for the risk of shares, a bargain of this kind is going to be harder to negotiate and may not be possible. However, if considered appropriate it would be possible - bank bailout style - to create a special class of employee share which had preferred capital and dividend rights.
 
What if the company is willing to effect redundancies? Redundancies may be unavoidable. The approach described here is, though, worth considering by companies which wish to minimise or avoid the loss of their talented people.
 
How do employees decide whether a deal is reasonable? Neither you nor your client could advise on this and I would recommend that employees be given the opportunity to obtain their own professional advice.