Share Schemes Training Session for HMRC Shares Valuation

Share Schemes Training Sessionfor

HMRC Shares Valuation

Pett, Franklin & Co LLP

At HMRC Nottingham

7th May 2014

Timetable

1. Introduction Barry Roland

2. UK Share Schemes Overview David Pett 12.30pm- 1.15pm

3. EMI share options Stephen Woodhouse

1.15- 2pm

4. Interval 2- 2.15pm

5. Black Scholes Accounting and topical valuation issues

William Franklin 2.15- 2.45pm

6. Questions and Discussion 2.45- 3pm

©2014 Pett, Franklin & Co. LLP

UK Share Schemes Overview

David PettPartner

www.pettfranklin.com

7th May 2014

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Introductions• Pett, Franklin & Co LLP

David PettWilliam FranklinStephen Woodhouse

• ‘the Book’ : “Employee Share Schemes” (2-vol looseleaf, pub. Sweet & Maxwell)

• The market for advice and implementation assistance

– lawyers vs accountants vs ‘consultants’– the roles of : Share Plan Lawyers’ Group ifsProShare Efes The Esop Centre Employee Ownership Association (“EOA”)

• tax/company law/employment law/securities laws/trust laws

• Largely separate administration industry including offshore trustees

©2013 Pett, Franklin & Co. LLP www.pettfranklin.com

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(Recent) legislative history• 1980: SAYE share options• 2000: EMI share options and Share Incentive Plans• 2003: Tax law re-write .... immediately followed by:

– change to charging rules for unapproved schemes and arrangements– MoUs re valuation of ‘management shares’ and ‘carried interests’– ‘opportunistic’ (ab)use of ERS....tax-free bankers’ bonuses; ‘employees’ trusts’

used to warehouse funds free of PAYE• 2010: Disguised Remuneration : was this the right response ...?• 2013:

– OTS reports on approved and unapproved schemes– ‘Shares-for-Rights’ – Geo. Osborne’s idea– the Nuttall Review of Employee Ownership– myriad technical ‘relaxations’ of rules re SIPs, CSOPs, SAYE– ER for EMI option shares

• 2014: E-filing/registration and further technical changes (eg re takeovers)


6

Practical commercial difficulties

• Avoiding a ‘dry’ tax charge : ERS are charged to IT when acquired, even if they are not immediately convertible into cash (OTS proposal?)

• Are the shares ‘readily convertible assets’ ? (if the co not independent, they will always be RCAs)

• ‘founders’ shares’ – are the shares acquired by reason of an opportunity in the course of a personal relationship ? (s421B(3))

• Is it a ‘close company’ ?• Assessing ‘hope value’ - the ‘information standard’ (MORE LATER)• ‘Restricted’ shares :

– inherent characteristics of a share vs restrictions– UMV vs AMV (given that a s431(1) election has become the universal ‘default’

option)– the ‘10% rule’ ?

• Companies operating an ‘internal market’ – who determines MV ?


7

Unquoted companies

• Allowing employees to benefit from future growth in value

• EMI options: if you qualify, is it a ‘no brainer’ ?• but what of ‘Shares-for-Rights’ ?• ‘unapproved’ share options• Joint Share Ownership (“JSOP”) awards• (so-called)‘growth shares’ ?


8

• Is an ERS acquisition taxed as a “right to acquire shares” ?...or as an acquisition of ERS at an undervalue ?– of concern to internationally mobile employees

• Is it a ‘general earnings charge’, or a Part 7 charge ?– different rules apply


9

Why is it so complex ?

Example:Private company owned by H & W wishes to allow a key employee to benefit from

growth in c. 9% of company;If co grants EMI option to subscribe for shares, exercised after 3 years, how does

employee realise the growth in value ?A sale back to the co will give rise to a ‘dividend tax’ charge on the growth in valueCo sets up an employees’ trust to buy back shares, but a loan to the trust attracts a

penal 25% tax charge ! If co buys back from employee, he gets CGT with ER, but if co then buys back from trust, deemed MV CGT charge on trust !

So, have to have (a) an upfront issue of the shares to an offshore trust at par using small loan (with 25% tax); (b) a contingent purchase contract (under CA 2006) to buy back shares from trust at par; (c) a cash contribution to fund the buyback by trust from the employee [co gets CT deduction for share option gain, not cash contribution]


www.pettfranklin.com 10

So, we need one more ‘tweak’……

• Allow employee shares to be repurchased by the company itself with no dividend tax penalty if bought back within 5 years

• avoids need for an offshore employees’ trust• it would allow an SME to:

– grant EMI options– secure CT relief for option gain– buy back shares out of reserves into treasury– thereby ‘ringfence’ employee shares

• Please support the lobbying for change….!



Participation in future growth in value can be achieved by :

• grant and exercise of 'market value' share options (EMI options; CSOP options; 'unapproved' share options)

• the creation and issue of a special class of 'growth shares'

• allowing the employee to acquire an interest as 'joint beneficial owner' on unequal terms under a JSOP ('joint ownership')

• a ‘founders’ SIP’ ?


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‘Employee Shareholder’ status (“SFR”): key Features

• Employee is issued with fully-paid shares in employer company (or holding company) worth at least £2,000 (after taking account of restrictions) for no consideration other than entering into a written ‘employee shareholder agreement’

• Employee treated as paying £2,000 (so first £2,000 of value is exempt from income tax and NICs)

• Insofar as the initial value, ignoring restrictions (IUMV), does not exceed £50,000, gain on sale is completely free of capital gains tax

• Better than EMI where gain is taxed as capital gain, albeit normally with reduced 10% ER rate

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• Employee has to forego certain key statutory employment rights

• Must be a written ‘employee shareholder agreement’

• Before agreement becomes effective, the employee must receive Independent Advice (paid by employer) and there must be a 7-day ‘cooling-off’ period


‘Employee Shareholder’ status: key Features


• shares can be in employer company or a parent undertaking• issuing company does not need to be independent !– of particular attraction to PE-backed companies

• no exemptions if employee has a ‘material interest’ (25% voting rights) or, if a close company, 25% of assets on distribution, winding-up (etc.) at, or within 1 year before, issue of employee shareholder shares

• no IT/NICs on acquisition/on first £2,000 of AMV• should company pay cash bonus to cover par value plus

IT/NICs ?

“Employee shareholder status”(or “Shares for Rights” )


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Advantages of SFR

• Within a limit, gain is completely free of capital gains tax

• Shares can be restricted/special class - but this reduces the IAMV

• Shares can be in a subsidiary• May be offered on a discretionary basis


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Disadvantages of SFR

• Statutory employment rights foregone (but rights under contract remain)

• Upfront tax charge (but first £2,000 tax free and value can be agreed in advance, so tax known)

• Lower limit for CGT relief (£50,000 compared with £250,000 for EMI)

• Shares must be issued (so cannot use EBT shares)...

• ...for no consideration (other than giving up employment rights)

• Company law problems


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Relief on sale back to company

• A sale back to the issuing company (for cancellation or to be held in treasury) is exempt from dividend treatment (even if the shares were not held for 5 years)

• but only if sold after the employee no longer a director or employee of that or any associated company

• Beware: gain on sale-back by continuing employee to issuing company is taxed as dividend income if shares not held for 5 years (etc)


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JSOPs: a summary

• Not share awards; not options• Employee jointly acquires shares with co-owner

(usually a trust)• Held under terms of JOA• Proceeds of sale unequal• Employee receives growth (less carry charge)• Co-owner receives the balance• Capital gains treatment for employee (like EMI)• Performance link


19www.pettfranklin.com

£

[ 2] % p.a. ‘Carrying’ Cost

SaleAcquisition

Tax point

Employee’s gain

Co-owner’s gain

3 years

‘Threshold amount’


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JSOP Benefits

• Growth taxed as capital not income • Employee pays tax at 28 % not 40 %+• Company saves NICs 13.8 %• Tax analysis repeatedly publicly accepted by

HMRC • Flexible• Same treatment as other shareholders on

takeoverswww.pettfranklin.com©2014 Pett, Franklin & Co. LLP

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JSOP Issues

• Shares in existence from start (hence carry charge)• Surplus shares trapped in conventional EBT if

performance condition fails (use GPT)• Close company loans to EBT• No CT relief on growth• Upfront cost of participation based on initial

market value of employee’s interest (IUMV)• Need to fix carry charge in advance


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When is a JSOP appropriate?

• If EMI options not available• Share value meaningful (or not certain that

HMRC will agree its not meaningful)• IUMV sufficiently low for upfront cost to be

economically feasible• Growth prospects; if share price can only fall

or flat line not much point as employee gets nothing



Comparison of 'growth shares' and JSOPs

• 'growth shares' require changes to the articles, but a JSOP is all in contract, so easier documentation;

• JSOPs require a 'joint beneficial owner' : an EBT or GPT– Guernsey Purpose Trust allows surplus assets to be

returned to company

• easier to administer JSOPs on a corporate transaction/'exit event'



There are plenty of reliefs/exemptions for employee share acquisitions

• EMIs/CSOPs/SAYE share options; • "Shares-for-Rights';• Share Incentive Plans

…but not so many upon a disposal of employee shares :

• 'Shares-for-Rights'• Share Incentive Plans• ER for EMI option shares



Changes in 2013 for SIPs

• OTS report on tax-advantaged share schemes– nearly all recommendations accepted

• Removal of pitfalls:– no ‘material interest’ test– removal of the penal clawback if company sold within 3 years for

cash– freedom to use restricted shares – but restrictions ignored for

valuation purposes– restrictions on transfer– good/bad leaver provisions– can be non- voting

– removal of need for a specified retirement age



What if the company is sold ?

• From 17 July 2013

• No tax on a withdrawal and sale of SIP shares pursuant to:– general offer to acquire control – a takeover offer (not defined)– a scheme of arrangement

• In consequence of which the participant receives cash (only) for SIP shares

• Must not be an alternative ‘shares- for – shares’ exchange on offer

• Avoids any risk of clawback if company sold early



Changes in 2014 to SIPs

• self certification/registration from 6 April 2014• increases in limits on tax-free shares

– Free shares £3,000 to £3,600– Partnership shares £1,500 to £1,800– Matching shares ( 2 for 1) £6,000 to £7,200– Dividend reinvestment (already no limit)

• annual returns to HMRC to be made electronically • Partnership shares: may allow obligation to sell on leaving

for at least amount of money used to buy Partnership shares (or MV, if less)

• new rules for enquiries and appeals


28

New registration and self-certification regime from 6 April 2014

• To qualify for tax reliefs, every CSOP, SAYE scheme and SIP must be registered with HMRC through PAYE Online Services– registration can only be done by a person with full access rights

• Existing schemes/plans must be registered before 6 July 2015

• All EMI plans and all unapproved schemes or arrangements must likewise be registered

• EMI grants must be notified online• Annual returns must be online


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Advantages of a SIP for founders (as against “growth shares”)

• Standard-form documentation

• Growth in value of “Founders” plan shares is entirely free of tax (exempt from CGT)

– Non-SIP shares probably entirely tax-free because of CGT nil-rate band

• Relative ease of administration

– Can normally be undertaken in-house

• GAAR?


Restricted Shares

• Problem:– pre-emption of SIP shares of leavers had to apply

to all shares of the class forcing an existing non-SIP shareholder employee to sell

• New regime:– shares can be subject to restrictions which only

apply to SIP shareholders

©2014 Pett, Franklin & Co. LLP www.pettfranklin.com 30

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Employee-ownership Trusts

• Exemption from CGT if individual (or trustee) proprietors sell a controlling interest to a new-style Employee-ownership Trust (“EOT”)

• If a sufficient number of unconnected employees, vendors can retain up to 49% and rights to all dividends

• Can use company’s own funds to purchase the shares • If company is later sold, a ‘clawback’ charge to CGT is levied

on the EOT trustee, not the vendor(s)• To avoid clawback, the EOT must retain indefinitely at least a

51% controlling interest


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Conditions for CGT exemption on sale to an EOT

• The company is a trading company (or holding co. of a trading group)

• the trust only allows benefits on an ‘all-employee/same terms’ basis

• the trust acquires a 51% controlling interest by the end of the same tax year

• the ‘limited participation requirement’ is met• the disposals (if more than one) must all be in the same

tax year


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Employee-ownership Trusts

• Relief from IhT if C, being a close company, makes a ‘gift’ of, say, cash to an EOT to fund the share purchase in the same tax year

• No relief from ‘loans to participators’ charge under s455 CTA 2010 on a loan by a close company to an EOT

• May still need a s701 ITA (“transactions in securities”) clearance if the EOT not acquiring at least a 75 per cent interest


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EOT

Hold Co

Trading Co

51% Note: Vendor can retain up to 49% (and 100% of dividends, if EOT trustees waive their dividends) provided the ‘limited participation’ requirement is met

sells ≥ 51%

of shares to EOT

Owner

100%

49%

https://www.google.com/url?q=http://austinkleon.com/2008/02/12/gerd-arntz-and-the-woodcut-origins-of-the-stick-figure/&sa=U&ei=5m8sU7v1JI-JhQfGkoHICw&ved=0CC8Q9QEwAQ&usg=AFQjCNF0biJrARbPGG5lG0iUC3wsMuHH0g

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The “limited participation” requirement (s236N)

NP must not exceed 2/5ths or 40%NE

NP = no. of 5%+ ‘participators’ (shareholders or loan creditors) who remain employees or directors (etc) (+ connected employees or directors)

NE = no. of group employees


36

Example:

• So, vendors (H & W ?) could retain up to 49% of share capital PROVIDED THAT (if they are the only participators who remain employees or directors, and they have no ‘connected persons’ who are directors or employees) the number of group employees is at least 6 (including H & W)

• If H retains at least 5% and W, son and daughter are employees (but have no shares), there must be at least 7 other employees (4 + 7 = 11; 4/11 exceeds 2/5ths)


37

Employee-ownership Trust

An EOT must:• only ever allow the fund to be applied for the benefit of

all eligible employees on a “same terms” basis and so that all eligible employees then receive benefit– may allow 12-month qualifying period– must exclude existing and former 5% participators and their ‘connected

persons’• not allow the creation of any trust of the fund, or making of loans

or by transferring property to another settlement (except another EOT)

• not include any possibility of amending the trust so as not to satisfy these requirements


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Clawback of relief

........ occurs if there is a “disqualifying event”, but the clawback charge is on the trustees, not the vendor

“Disqualifying event” is:– ceasing to be a trading company (etc)– the trust ceases to hold a 51% controlling interest– the participator fraction exceeds 2/5ths– trustees breach the ‘all-employee’ benefit requirements

• Immediate disposal and re-acquisition at market value • [What if the EOT trustees are non-UK ? ]


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“Employee Ownership Trusts”

B. Relief from income tax on employee bonus payments• Qualifying bonuses of up to £3,600 paid to all qualifying

employees on a “same terms” basis will be exempt from income tax (but not NICs)

• Only available if the company is owned by an “Employee Ownership Trust”

• May differentiate on a linear basis according to length of service, salary level and/or hours worked

• From 1 October 2014


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Tax-free bonuses paid to all-employees of an EOT-owned company

• Must be a ‘bonus’ payment by the employer company • Must be paid on a ‘same terms’ basis to all eligible group

employees and not to only those in a particular member or function

• Employer must not be a ‘service company’ (ie providing services outside the group) or a ‘managed service company’

• No. of office holders (+ connected persons) as fraction of all employees + office holders must not exceed 2/5ths

• Must be no “salary sacrifice” arrangements


EMIBenefits and Requirements

Stephen WoodhousePartner


Pett Franklin/HMRC Seminar7th May 2014

42

Target Companies

• Small companies (defined by reference to maximum £30m of gross assets)

• Typically owner managed due to independence requirement

• May also apply for certain private equity backed companies with no 51% corporate shareholder


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Tax Benefits

• No tax or NIC charges on grant of options• No tax or NIC charges on exercise of options if

exercise price no less than MV on grant• Corporation Tax relief on exercise on intrinsic

value on exercise (if relevant conditions for CT relief are fulfilled)

• CGT on sale but potential for entrepreneur’s relief to reduce effective rate to 10%


44

Tax Benefits

Fact Pattern Values

MV of shares subject to options on grant £50k

Total exercise price of option £50k

MV of shares when options exercised £500k

Tax on grant Nil

Tax/NICs on exercise Nil

Corporation Tax relief on exercise £90k

CGT on sale at £500k £45k

Net Tax position £45k recoverable from HMRC


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Main Requirements: Value Limits

• Legislation in Sch 5 of ITEPA• Para 4 – must be granted for “commercial reasons” to

“recruit or retain” an employee and not for tax avoidance

• Para 5 – employee may not hold an option in respect of shares worth more than £250k by reason of employment with one company or group;

• Option over excess value is not a qualifying option in relation to the excess

• Measurement of value includes value of CSOP options


46


• For these purposes:– Value = “market value, at the time when the

option is or was granted, of issued shares of the same class as those that may be acquired by exercise of the option”

– Market value is CGT definition (Para 55) but ignoring restrictions (Para 5(8))

– £250k limit extends over three years (Para 6)


47


• Para 7 – total value of shares subject to unexercised options must not exceed £3m (applying same valuation rules as for £250k limit)


48

Qualifying Companies: Independence

• Para 9 = not a 51% subsidiary or controlled by (a) another company or (b) another company and any connected person

• No arrangements to become such a subsidiary or fall under such control (other than arrangements for a “qualifying exchange of shares” – i.e. a share for share exchange in the context of a reorganisation


49

Qualifying Subsidiaries

• Para 10 - all subsidiaries must be “qualifying” if parent is to issue EMI options

• Subsidiary is any company which parent controls either on its or with any person connected with it (applying close company control test)

• Qualifying subsidiary requirement is that subsidiary is:– 51% subsidiary of parent– No person other than parent controls the subsidiary– No arrangements are in existence by virtue of which either of the first

two conditions would cease to be met• Also, parent must not have a “property managing subsidiary

which is not a 90% subsidiary (paras 11A and 11B)


50

Gross Assets/Number of Employees

• Gross Assets Test (Para 12)– Gross assets of a single company do not exceed £30m

at date of grant)– With a group, the gross assets test applies to the

aggregate gross assets of each member of the group, disregarding any intra-group assets or shares or securities in other group members

– Looking at gross assets shown in the accounts – can catch small companies with unusual accounting conventions (e.g. insurance brokers with client money)


51

Number of Employees

• Number of Employees (Para 12A)– Full time equivalent number of employees must

be less than 250– Full time equivalent based on a “just and

reasonable” basis (see HMRC Manual)– Excludes employees on maternity or paternity

leave or students on vocational training


52

Trading Activities

• Single company (Para 13) – must exist wholly for the purpose of carrying out one or more qualifying trades and is carrying on a qualifying trade or preparing to do so, subject to being allowed to:– Hold and manage property used by the company

for one or more qualifying trades carried on by it– Have purposes having no significant effect on the

extent of the Company’s activities


53

Trading Activities

• Parent Company (Para 14) – at least one group company satisfies an equivalent to the single company test: and

• The business of the group does not consist as to a substantial part in the carrying on of non-qualifying activities

• Business definition disregards holding shares or securities or making loans to other group companies, holding and managing property used by a group company for the purposes or one or more qualifying trades carried on by a group company or incidental activities.


54

Qualifying Trade

• Qualifying Trade is (Para 15) conducted on a commercial basis and with a view to the realisation of profits and does not consist to a substantial part in the carry on of excluded activities.

• R&D supported in that R&D from which it is intended that a connected qualifying trade will be derived or benefit counts as the carrying on of a qualifying trade.


55

Excluded Activities

• Dealing in land, commodities, futures, shares, securities or other financial instruments or goods “otherwise in the course of an ordinary trade of wholesale or retail distribution”

• Banking, insurance (but not insurance broking), money lending, debt factoring, HP financing or other financial activities.

• Leasing including letting ships on charter or other assets on hire

• Receiving royalties or licence fees• Providing legal or accountancy services• Property development


56

Excluded Activities

• Farming or market gardening • Holding, managing or occupying woodlands, any

other forestry activities or timber production• Shipbuilding• Producing coal or steel• Operating or managing hotels• Operating or managing nursing homes or

residential care homes• Provision of business facilities


57

Advance Assurance

• Facility for company to write to Small Company Enterprise Centre to seek assurance before options are granted before the grant occurred

• If full facts are given and are accurate, this assurance will mean that the Company is a qualifying company for as long as those facts remain unchanged


58

Employee Requirements

• Employment (Para 24)– Must be employed by the company granting the options or a

qualifying subsidiary of that company– Concept of “committed time”; employee must have “committed

time” of at least 25 hours per week or 75% of employee’s “working time”

– Working time means time spent as an employee or self-employed person on remunerative work which for an employee means work the remuneration from which are general earnings for tax purposes

– Working time includes absences for injury, ill health, disability, pregnancy, childbirth, maternity, paternity or parental leave, reasonable holiday or notice periods


59

Employee Requirements

• No material interest (Para 28) in any group company by employee or associated person

• Material interest threshold is 30% in the company or, if a close company, the assets of the company, covering beneficial ownership or in case of assets, 30% of assets available for distribution on a winding up

• Shares includes shares which may be acquired on the exercise of an option but excluding shares subject to qualifying EMI options and shares held in a SIP in accordance with the plan but which have not been appropriated or acquired by an individual

• Also, excludes EBT shareholding except where individual has had a 30% interest


60

Option Requirements

• Type of shares (Para 35)– Part of the ordinary share capital– Fully paid up (with an undertaking to pay not making the

shares fully paid up)– Not redeemable

• Option to be capable of being exercised within 10 years of grant and any performance conditions must be capable of being fulfilled within that 10 year period (para 36)

• Option terms must be in writing (see later)


61

Reorganisations

• Part 7 of Schedule 5 provides for relief where acquiring company:– Acquires control of EMI company through a general offer

or acquires all shares of the class subject to EMI relief through a general offer

– Obtains control of EMI company through a court compromise or arrangements

– Becomes entitled or bound to acquire to buy out shareholders through “squeeze out” procedure

– Obtains all the shares in EMI company through “qualifying exchange”.


62

Reorganisations

• Facility (Para 41) for the grant of replacement options on tax protected basis where replacement options:– Granted within six months of acquirer obtaining

control– Satisfy the normal EMI requirements for the purpose

of granting options, value of options and Para 5 requirements relating to options

– Other detailed requirements relating to the replacement options are satisfied


63

HMRC Notification

• To be a qualifying option, the employer must notify HMRC of the grant of the option in the specified form within 92 days of the grant of the option

• Subject to reasonable excuse for delay, failing to notify within 92 days results in the options not being qualifying for EMI purposes (Para 44)


64

Documentation

• In order to qualify, the option must be “in the form of a written agreement between the person granting the option and the employee” meeting certain conditions (Para 37)

• Question whether to use individual option agreements with individual terms or single set of plan rules with option agreement incorporating terms

• In either case, the option agreement must state:– The date on which the option is granted;– That it is granted under the provisions of Sch 5 of ITEPA– The number or maximum number of shares that may be acquired– The price (if any) payable by the employee to acquire them, or the method

by which that price is to be determined; and– When and how the option may be exercised


65

Documentation

• Also the option agreement must:– Set out any conditions, such as performance conditions,

affecting the terms or extent of the employee’s entitlement

– Where the shares are restricted shares (within the normal meaning of Part 7, ITEPA), details of the restrictions.

• Overall, while the share rights are contained in the Articles, the option agreement needs to provide a comprehensive description of the key option terms.


Project Plan for EMI Scheme

Responsibility DeadlineProvide information requested for share valuation

COMPANY G-30

Prepare note on targets in order for PF to draft performance conditions

COMPANY G-30

Determine quantum of awards COMPANY G-23Review Articles to establish if amendments might be necessary

PF G-23

Prepare draft EMI scheme rules and option certificates

PF G-23


Responsibility Deadline

Prepare draft share valuation report PF G-22

Review draft valuation report and supply written comments with telephone call if necessary

COMPANY G-20

Prepare and submit final valuation report to HMRC PF G-19

Review draft scheme rules and in particular:- Definition of “good leaver”/”bad leaver”- Meaning of “exit event”- Performance targets - Time-based vesting conditions for possible future

awards

COMPANY G-19

Consider comments and feedback (possible meeting/telcon)

PF/COMPANY G-16


Responsibility DeadlinePrepare amended scheme rules PF G-14Draft employee communication including letter explaining risk of disqualifying events

PF G-14

Prepare draft board/shareholder minutes and resolutions for establishing scheme

PF G-14

Follow up valuation with HMRC PF G-12Second review of draft scheme documentation (written feedback)

COMPANY G-12


Responsibility

Deadline

Prepare final versions of scheme rules and ancillary documentation

PF G-5

Assume valuation agreed by HMRC (Note this timetable assumes HMRC agree valuation within 2 weeks of submission).

HMRC G-4

Prepare individual option documentation including Form EMI1s

PF G-3

Issue option documentation to employees COMPANY G -2Execute documentation and grant options to employees

COMPANY G Date


Responsibility DeadlineReview executed documents and submit Forms EMI1 to HMRC

PF G+3

Prepare document bible including company proforma documentation suitable for future awards and copies of the actual awards

PF G+4


Black Scholes Accounting etc

William FranklinPartner


Pett Franklin/HMRC Seminar7th May 2014

“Something must be done”

• Mid 1990s in US CEO pay controversy, growth delivered by share options.

• Some investors (e.g. Warren Buffet) complain no expense in companies accounts for this compensation: Accountant’s fault

• Something must be done- US Financial Accounting Standards Board (FASB) proposes an expense based on “fair value” of options- “Share Based Payment”


FASB

• Private sector non- profit organisation run by accountants to set accountancy standards in the US.

• Very proud, very independent institution • FASB Share Based Payment expense greeted by horror by

US corporates. – If US companies are forced to adopt this and the rest of the

world (particularly UK) does not then US companies will relocate to the UK etc.

• Congress lobbied – Threatened to withdraw funding

• FASB- backs down


Shock at politicisation

• Leading accountants around world plan counter attack (including UK: David Tweedie)

• Have to deal with accounting standard in one country problem • 2000 G4 +1

– discussion paper • Drive to International standards• But US standards very legalistic in style • Enron shakes confidence in US Accounting Standards generally. Result :

– The unthinkable happens US accountants co-operating with accountants around the world.

– Manifested by a joint convergence project on Share Based Payments. • Outcome IFRS2 (FRS20) FAS123


Share Based Payment

• Problem : How do you get a “cost” for the issue of an option when there is no payment of cash

• Answer : use market value of options• Problem : but do not exist• Answer : Work out a theoretical figure


Standard

• Does not say use Black Scholes • Says must calculate a “fair value” using 6

assumptions which are the 6 assumption of Black Scholes and disclose these 6 assumption in the Financial Accounts

• Bizarre... Standards do not normally require assumptions of accounting values to be disclosed. Policing assumptions is why there are independent auditors.


Black Scholes and Merton

• In 1970s some academic economists propose that a 19th Century Formula for heat transfer could be used to value options.

• Win Nobel prize for Economics (Note Not Maths)

• Barack Obama said some strange people receive Nobel prizes


“any colour as long as it is black” Black Scholes

021

2

222

rV

tV

SVrS

SVS

volatility

price of commodity

risk-free interest rate

with respect to

time

price of financial derivative

rate of change

78

Hard maths

• Maths developed by Newton• Beyond understanding or training of

99% of accountants


Black Scholes Six

• Share price at date of option grant• Exercise price of option• Expected Life of option• Expected future dividend yield• Risk free rate of return• Expected future share price volatility Note – Nothing about future expectation of share

price performance or past trends in share price.


Fundamental Problems

• How do you predict future volatitlity ?– relevance of different past volatilities – business changes over time

• Assumes shares follow normal distribution


Normal Distribution

Features of Normal Distribution

• Mean Average = most frequent• Spread = standard deviations (“volatility link) 66% = within 1 SD95% = within 2 SD99.7%= within 3 SD • Lots of physical phenomena follow Normal

Distributions (e.g. Heights of people)• Lots of maths developed ©2014 Pett, Franklin & Co. LLP

Nonsense

• Shares do not follow Normal Distributions• Remember Black Friday• Share prices moved by 20 SDs• Average American women 163 cm• SD of 10 cm• Like finding an American woman 363cm tall


Tall woman


In meantime

• No evidence that SBP charges actually reflect reality of costs of employee options

• Credit crunch– Failure by banks to value derivatives

properly• Black Scholes– Tested ideas to limit LTCM – another

government bail out.


Why did standards setters press on ?

• Had no alternative were committed• Davos debate• Actually proud they did not understand the maths.• Claimed they left calculations to companies but weasle

words because of the Black Scholes 6 Assumptions• Black Scholes used by banks to value financial derivatives • In fact for short life option (few months) there is a traded

market which sets price- implied volatility poorly correlated

• Volatility smile


But

• Standard setters did not really care what the figure was as long as there was a figure

• Analysts could ignore the expense or recalculate it by changing the assumptions (why there is disclosure). In fact they now usually disregard it as a non-cash expense

• Now largely ignored: Accountants who don’t understand the maths do not care, knowing it does not matter and subcontract the calculations to actuaries who have been looking for work with abolition of final salary pension schemes in the private sector continue but do not understand financial accounting.


Employee Share Option’s

• Employees can’t exploit volatility like traders• Interested in long term growth prospects• High volatility overstates value of an option to

an employee


Zero Volatility


Share price

Time 1 Time 2

Company A’s share price does not move over time

High Volatility


Share price

Time 1 Time 2

Company B’s share price does not show an overall increase but is highly volatile

Although, the expected growth in the share prices of both companies is the same (nil), Company B is much more volatile and so its Black Scholes value would be higher.

Ball park only

• Black Scholes for Employee options can only give a broad ball park value at best

• Need to look at other methods e.g. Capital Asset Pricing Model

• In future Game Theory and Quantum Mechanics may provide better methodologies


Information Standard

• Valuing growth or hope potential • Access to confidential

information: forecasts• Lack of consistency –sick founder confidential


Discounts for Minority Interest

• Shares in subsidiaries• Examples in SFR• Is the normal 70%+ discount applicable ? • Does existence of corporate controlling

shareholder automatically make minority holding in a company more marketable ?

• We do not assume this for an individual majority shareholder so why should we for a corporate shareholder ?


Hope Value

Enterprise value £10 millionDebt: external and shareholder £15 million

Negative Equity (£5 million)


How can the equity have any value ?

Any hope value is already reflected in Enterprise value

• Questions and Discussion


Contact details

David Pett [email protected] mobile: 07836 657 658

William Franklin [email protected] mobile: 07889 726767

Stephen Woodhouse [email protected] mobile: 07836 756031

Office: 0121 348 7878

Twitter: www.twitter.com/pettfranklin

For lots of information, go to our website:www.pettfranklin.com


mailto:[email protected]



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Share Schemes Training Session for HMRC Shares Valuation

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Transcript of Share Schemes Training Session for HMRC Shares Valuation