Growth Shares Explained: UK Design, Valuation and Tax

What are growth shares?

Growth shares are a class of UK company shares engineered to participate only in the *future growth* of the business above a defined value threshold - the hurdle. They have no entitlement to the value built up to date. If the company is sold for less than the hurdle, the growth shares are worth nothing; if it is sold above, the holders share in the upside alongside the ordinary shareholders.

That single design feature - a hurdle that strips out existing value - is what makes growth shares the most flexible equity-incentive instrument available to UK private companies. They are widely used as an alternative or complement to EMI options and as a core tool in succession and family-business planning.

Why companies use growth shares

Growth shares solve five recurring UK problems:

• Incentivising management without giving away existing value. Founders can issue equity that captures future outperformance without transferring the value created to date.
• Reaching employees and contractors who do not qualify for EMI. EMI is restricted by company size, sector, employee status, working time and option-pool limits. Growth shares have none of those gating conditions.
• Cap table flexibility for non-employees. Advisors, consultants, family members, trusts and corporate partners can hold growth shares; EMI options cannot be issued to them.
• Family succession and IHT planning. Combined with a freeze-and-growth reorganisation, growth shares channel future value to children, grandchildren or trusts at low day-one tax cost.
• Capital gains treatment of upside. When properly structured and supported by a section 431 election, all growth above the hurdle is taxed under the CGT regime rather than as employment income.

How growth shares work

The mechanics rest on the hurdle. Three numbers matter on a future exit:

1. The hurdle - the agreed value of the company at the issue date, often with an annual coupon (5%-8%) added.

2. The sale proceeds at exit.

3. The excess - the difference between the two, distributed pro-rata across the ordinary and growth classes (subject to whatever waterfall the articles specify).

Below the hurdle, the growth class receives nothing. At the hurdle, the growth class is worthless. Above the hurdle, the growth class participates - typically alongside the ordinary class on a pre-defined ratio.

The growth class is, conceptually, an option on enterprise value above the hurdle. That is why option-pricing models (Black-Scholes, binomial lattice) feature prominently in growth-share valuations.

Growth shares vs EMI options

The two instruments overlap in purpose and diverge in mechanics. The honest answer is that, when EMI is available, EMI is usually the better tool; growth shares are the right answer when EMI is not available or when the structure needs to do more than incentivise employees.

EMI is usually preferable where eligibility is met: no day-one cost to the holder, no day-one tax event, simpler valuation, well-trodden HMRC route. Growth shares come into their own where EMI is not available, where non-employee holders need to participate, or where the structure needs to ringfence existing value for succession purposes.

The role of valuation

A growth share valuation answers three questions:

• What is the hurdle? This is the market value of the company at the issue date, usually set equal to enterprise or equity value. It defines the floor above which the growth class participates.
• What is the AMV of a growth share at issue? This is what the holder pays - or is taxed on, if the share is gifted. A correctly-designed growth share has an AMV that is low but not zero, reflecting the option value over the hurdle.
• What is the UMV? If the share is employment-related and restricted (good leaver / bad leaver, pre-emption, forfeiture), the UMV is the value ignoring those restrictions. UMV is used for the section 431 election; AMV is used for the income tax calculation if no election is filed.

UK practice is to derive enterprise value using earnings-multiple and DCF analysis, then to derive the growth-share value using an option-pricing model. A Black-Scholes calculation requires:

• The hurdle (strike price).
• The current equity value per share (spot).
• The expected time to exit (typically 3-7 years).
• Volatility (typically 25%-40% for UK SMEs, anchored against listed comparables).
• The risk-free rate (current UK gilt yield over the time horizon).
• Dividend yield, where the ordinary class pays dividends not shared with the growth class.

The output is the per-share value of a growth share at issue - typically 1%-5% of enterprise value per percent of fully-diluted equity.

Tax treatment

Growth shares are almost always employment-related securities when held by employees or directors. The standard pathway is:

1. Subscription at AMV. The holder pays AMV in cash, often funded through a personal contribution, a director's loan or a salary sacrifice arrangement.

2. Section 431 election within 14 days. Joint election by employer and employee under section 431 ITEPA 2003, electing to be taxed on the UMV at acquisition rather than the AMV. The election shifts all future growth into the CGT regime and removes the risk of future income tax and employer NICs charges.

3. ERS reporting. The acquisition is reported on the annual ERS return (Form 42 / employment-related securities online filing).

4. Holding period. Growth shares are held until the exit event.

5. Disposal. On sale or buyback, the gain is taxed as a capital gain. Business Asset Disposal Relief may be available if the standard 5% / 24-month tests are met against the growth-share class.

For non-employee holders (family, trusts, advisors), the income tax / ERS analysis falls away. The principal considerations are CGT on disposal, IHT planning (Business Property Relief after the two-year holding period), and stamp duty on issue and subsequent transfers.

Why section 431 matters so much

A growth-share scheme without a section 431 election is a tax accident waiting to happen. The risk is straightforward: HMRC can argue at any point in the future that the share was restricted at acquisition and that the growth above the AMV-at-acquisition figure is employment income, not capital gain.

The election eliminates that risk by deeming the holder to have acquired the share at its unrestricted market value, paying any required income tax up front. Because the AMV/UMV gap for a well-designed growth share is typically small, the election usually costs little or nothing - and protects all future growth.

The election must be made in writing, jointly by employer and employee, within 14 days of acquisition. Missing the deadline is not retrievable.

Designing growth shares

The articles need to specify, at minimum:

• The hurdle, expressed as a cash amount with any annual coupon.
• The ranking on a sale or winding-up - participation above the hurdle, the ratio versus ordinary shares, any cap or super-participation.
• Dividend rights - usually none, or a small participating right that supports day-one value funding.
• Voting rights - usually none, to keep control with the founders.
• Pre-emption - mandatory transfer on a leaver event, with a buyback price linked to fair value or a defined formula.
• Good leaver / bad leaver provisions - mandatory transfer at fair value (good) or par / nil consideration (bad).
• Tag-along and drag-along - growth-share holders tagged into any sale of the controlling block; dragged into a 75% / 90% sale.

A clean design balances commercial flexibility with HMRC defensibility. Over-engineered participation rights and unusual waterfalls invite SAV review and complicate the valuation.

Worked example

A UK SaaS company is worth £8m and has three founders holding all the ordinary shares. It does not qualify for EMI because it is too large by gross assets (its recent capital raise pushed gross assets above £30m). The board wants to incentivise the senior management team of four with equity worth approximately 8% on a fully-diluted basis if the company doubles in value over five years.

The structure:

• Hurdle: £8m, with a 5% annual coupon over five years - approximately £10.2m terminal hurdle.
• Growth class: 8% of fully-diluted equity, participating pro-rata above the hurdle alongside the ordinaries.
• Allocation: 2% each to the four managers.

The valuation:

• Enterprise / equity value at issue: £8m.
• Time horizon: 5 years.
• Volatility: 30%, anchored against listed UK and EU SaaS comparables.
• Risk-free rate: 4%.
• Black-Scholes output: each 1% of growth shares has an AMV of approximately £25,000. The full 8% allocation has an AMV of approximately £200,000, or £50,000 per manager.
• UMV: approximately £210,000 (a modest restricted/unrestricted gap).

Each manager subscribes for £50,000 in cash and files a section 431 election within 14 days. Five years later the company is sold for £16m. The growth class receives 8% of the £5.8m excess - approximately £464,000, or £116,000 per manager. The gain (£116,000 less £50,000 = £66,000) is taxed as a capital gain, with BADR potentially available subject to the standard tests.

When growth shares are not the right answer

Growth shares are a flexible tool but they are not always the right answer.

• EMI is available and meets the design objective. EMI is simpler, cheaper, more familiar to advisors and recipients, and has no day-one cost to the holder.
• The holder cannot fund the subscription. Even at AMV, a growth-share allocation has a cash cost. Options are funded only on exercise.
• A near-term exit is in contemplation. With a short time horizon and a known sale price, the day-one AMV of growth shares can be substantial - and the income-tax risk on issue significant.
• The company has no realistic value-creation runway. If the company is mature or declining, the growth class has nothing to capture.

Common mistakes

FAQ

Related guides

• Section 431 election - the 14-day election that secures CGT treatment for growth shares
• Freeze and growth reorganisations - the corporate-structure context in which growth shares are most commonly issued
• UMV vs AMV explained - the two values reported for every growth-share issue
• EMI valuation guide - the most common alternative to growth shares for UK employees
• Minority discount - the discount framework that applies to non-controlling growth-share holdings