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Share Options and Ancillary Relief Claims

David Black, a forensic accountant with Haines Watts, explains the background, valuation and planning issues surrounding share options in ancillary relief cases

David Black, Haines Watts

Introduction
Share options are normally of more interest in a rising stock market rather than in the downward spiral experienced a few years ago. However, since March 2003 the stock market has been rising steadily so values for options may again begin to be material in the near future.

In principle a share option is the right to buy shares at a specified future date at a price set at the date the option is granted. If the share value rises and the recipient complies with the scheme's rules about how long to hold them then he will enjoy a possibly substantial bonus at the end of the period. If the share price does not rise then the recipient can choose not to exercise the right to buy.

My experience in assessing the value of share options began in the context of personal injury claims. When subsequently I wrote a dissertation on the subject for the purposes of a fellowship of the Chartered Insurance Institute, I found that there was plenty of information explaining what share options scheme were, how to set them up and how to know whether they were of a type approved by the Inland Revenue (HMRC as now) or not. However, there was a lack of literature explaining anything about the financial implications of early termination or interim valuations of options.

In the 1990's, when the stock market was rising, I became involved in cases relating to divorces. These included one that resulted in a professional negligence claim against a solicitor for failing to take into account in a settlement share options granted to the husband. This case alone underlines the importance to family lawyers of understanding how share options schemes work and the value that might be attributable to them. In this article I will outline the background principles, discuss valuation options, give some examples and suggest what can be done.

Background
The initial approach to share option scheme for employees is to try and ensure that they are tax efficient. HMRC approved schemes have major tax advantages over unapproved schemes but for some companies trying to supply incentives to senior managers, the unapproved route has more flexibility.

The basic scheme, particularly for quoted companies, used to be the share save scheme. Here one contracted to save £x per month for five or even seven years. A price was set for the shares at the start which could be as much as 20% below the market price at that date. At the end of the period the option holder qualified for bonuses to help buy more shares depending upon whether the scheme ran for five or seven years. Alternatively one could draw out the funds with the bonus being tax free. It was then possible to invest in a new savings scheme the next year and so on ending up with five or more active at the same time. However the total contributions per month could not exceed £200. Many such schemes are still in progress.

With the discount on the share price and the bonus for completing the saving period, there was normally some profit in it for the recipient, particularly if the gain from buying and reselling the shares was less than the personal capital gains tax annual exemption. The main problems arise if one has to terminate the savings early, normally because of a takeover or redundancy, as the bonuses are lost.

In 2003 the system was changed courtesy of the Income Tax (Earnings and Pensions) Act (ITEPA 2003). This needs an Employee Share Trust to hold shares for issue to employees in accordance with the guidelines for Share Incentive Plans where there can be free shares, partnership shares, matching shares and dividend shares. Free and matching shares are issued by the company for values that cannot exceed £3,000 in any one year. Partnership and dividend shares are paid for by the employee up to £1,500 per year effectively by reducing taxable income.

These share options have to be available to all eligible employees but can be graduated so that the number received free or matching purchase of partnership shares, varies depending upon salary, length of service and performance. For most companies there will be an expectation that the shares are retained by the option holder for a period as specified in the HMRC approved Incentive Plan.

Next we have various schemes for executives including those involved in "high tech" start ups and developments. The restrictions on the share save or incentive plan schemes become less onerous but one still has to hold the options for a number of years before they confer rights to obtain shares. If the scheme is for a quoted company then it is possible to sell the shares on the stock market but if for a private company much of the value may be locked in unless the company is taken over or becomes quoted. The logic of options in unquoted companies is to help develop staff loyalty and interest in growing the business from a situation where the salary package may be restricted initially but the potential is good.

Finally we have unapproved schemes. These may arise with foreign owned firms where option arrangements for the parent company shares are difficult to set up or where a company wishes to give particular performance related incentives to senior managers or main board directors. These schemes produce the largest tax bills and are most difficult to evaluate at an intermediate stage. However they are also the ones that should have the greatest impact on assets available to share.

Valuation of options
While it may not be possible to release any cash from the scheme it is possible to estimate a value on options held in a quoted company from knowledge of the share price at a specified date and the terms of the option agreements. There are frequently several schemes running concurrently as a new scheme may be offered to the employee each year. It is also possible to value the options at maturity assuming the share price does not change. That value will normally be higher than a valuation of options as they are at the specified date.

With unquoted shares there may be an informal market with prices set from time to time. Here the problem is getting access to the price information as the company may not wish to advise values except at certain specified dates each year. Accordingly it is possible that the advised share price will be almost a year out of date when required.

The more likely problem with unquoted companies is that in order to obtain a share price the valuer needs to review the memorandum and articles of association to know what guidelines are included there, if any, and to prepare a valuation of the company, its shares and the options. That is seldom inexpensive but it may be necessary if there is the potential for a lot of value to be locked up in the shares and the options. Unless the option holder has only been with the company for a few years some options may have matured and become a shareholding.

ITEPA 2003 sets out conditions for approval of a Plan that includes all shares being available at the same price. That tends to mean that individual shares are valued pro-rata to the value of the whole company with no discount for small minority shareholdings and no special discounts on the purchase price to a favoured few.

Examples
As I have mentioned, there is a risk for the family lawyer who fails to take account of share options of a claim for professional negligence. In the case I referred to earlier, the solicitor representing the wife accepted assurances that the husband's share options had no value and that, in any event, there was no way of determining their value as the husband's employer was unquoted. However I found that there was an annual informal market for selling the "shares" when the options matured as it was not possible to buy shares directly in the foreign owned parent. Since this was an unapproved scheme, the staff were then taxed on their gains each year as if those gains were income. The husband had gains, after tax, of £600,000 in the five years after the divorce settlement from maturity of options he had in place at the time and the ex-wife received none of that income.

In another case, a lady employed by a major bank had several share save schemes running concurrently when she was made redundant. The terms of the scheme meant that she was forced to resign from the scheme shortly afterwards without buying shares or receiving her completion of contract savings bonus. She was only saving £25 per month per scheme but she did have several running. From losing the discount, share gains and the bonus she forfeited £10,000. She could have reduced her loss by buying the shares and reselling them almost immediately but she was too distraught to select the best course of action. Although this situation arose in the wake of redundancy, it is a common problem when traumatic events like separation and divorce occur. The lady in this case did not consult anyone on her options in a situation where some accounting calculations could have assisted her.

Another example is a company director given options when floatation on AIM is a possibility. The valuation of the company at the time of the grant of options will be based on the formulae used for those that are unquoted. A typical example uses an earnings multiple of five. If we assume the director receives options on 100,000 shares at £2.50 each and two years later the company floats on an earnings multiple of twelve with profit growth in between, the share price could be the equivalent of £10 each. Being able to exercise the options is worth £750,000 immediately before HMRC become involved. It is possible that the option arrangement is tax approved and in those circumstances the maximum tax charge may be less than £75,000 if all the shares are disposed of at £10 each. Exercising the options and disposing over time could reduce the charge further or result in greater gains. If the option scheme was unapproved then a tax and NIC charge of 41% is the more likely outcome with a gain of £442,500. The spouse claiming a share of the option value would probably want the same percentage as awarded in relation to other assets and a share in the uplift in the value of any existing shares in the company because it has floated. To do that they probably need to be allocated shares and an earmarked proportion of the options as part of the settlement so that the risk of things going wrong is shared.

By way of a slight digression, care should also be taken to look into tax options for similar reasons. A husband consulted me on what to expect once divorce proceedings commenced. I outlined my understanding of what he could expect and explained that any asset transfers done in the tax year of the separation would assist tax mitigation because of the spouse transfer exemption. Effectively if one is going to separate, do it at the start of a tax year as there is then more time to negotiate asset transfers and do take advantage of the rules or some of the disposals will result in HMRC taking a cut. That may mean solicitors advising their clients to go and talk to their accountants about asset transfer options early in proceedings rather than at the end. Both parties have more assets if some transfers help to mitigate tax liabilities to enable the inevitable transfers to take place.

What can be done with share options?
In theory share options have no value until they mature and all of the other conditions apply. However that assumes that the recipient is going to change employment and forfeit benefits. That is seldom done voluntarily. Accordingly one either determines a potential value for the options as of the date of valuation and uses that in the asset allocation negotiations or one agrees a percentage of the net proceeds be passed over on maturity of the option(s).

If the recipient chooses to retain quoted shares that should not be a problem. All that has to happen in those cases is for a cash transfer to take place to redistribute the value between the parties. For unquoted shares that are tightly held there may be more difficulty proving a value and releasing funds but it is then a share valuation problem rather than a share option one.

From my understanding of the lack of trust that develops during divorces the initial demand is often for as much of a clean break as possible. Share options are an area where clean breaks based on current values are liable to work against the party claiming a share of the other's options despite the downside risk of another stock market crash. It is not always a cost that one wants to incur but professional accountancy advice is essential as part of the process of assessing the best course to take if there could be significant value involved. For those representing a spouse with options, early disclosure of the company memorandum and articles of association and terms of the option or incentive plan is recommended as they should be included and valued in Form E.

David S Black is a Chartered Accountant who has also qualified as a Chartered Insurance Practitioner and Chartered Loss Adjuster. He is a partner in Haines Watts, specialising in litigation support and he has FSA authorisation for claims mediation. He can be contacted on 01902-793333 or at dsblack@hwca.com.