Your comprehensive guide to growth shares

As a startup founder, you are continually exploring ways to reward your workforce for driving growth without overly diluting the existing value of the company. Growth shares offer an effective solution to this challenge. They represent a special class of equity designed specifically to incentivize employees, executives, or key advisors by tying their financial rewards directly to future company performance. 

Unlike traditional equity options, growth shares have minimal value when issued because their worth is linked to future appreciation above a predetermined company valuation, known as the hurdle rate. Growth shares are a valuable tool for aligning employees' interests with the company's long-term success. 

Employees holding this special class of shares benefit significantly only if they help grow the business beyond the set valuation threshold, ensuring motivation remains directly linked to tangible outcomes. This blog examines various aspects of a growth share scheme, including its operation, unique benefits, and key considerations. Let's begin.

Growth shares were first introduced in the United Kingdom as a tax-efficient way for private companies to reward key employees and advisors. They initially gained popularity among British startups seeking to motivate their teams without diluting their existing equity upfront. 

Over time, this concept gained international traction, becoming particularly attractive in startup hubs such as Silicon Valley and New York. Today, growth stock plans are widely adopted by US startups due to their flexible structure and clear alignment with long term business performance. Unlike traditional equity instruments, a growth share plan provides recipients with value tied exclusively to future increases in the market value of the company. 

This means your employees earn rewards based explicitly on performance and recent earnings they directly help achieve rather than gaining immediate value of the growth shares. This design makes growth shares particularly appealing as incentives, especially when aiming to retain critical talent through periods of rapid scaling. By implementing growth shares, you are better positioned to incentivize your team effectively while maintaining control over initial equity dilution.

What are growth shares?

A growth share is a type of equity that allows holders to benefit from the future increase in a company's value. Their worth depends on a specific valuation threshold called the hurdle rate, the company's value must exceed this hurdle for growth shares to carry any financial benefit.

Growth shares are widely used by startups and private companies as a tax-efficient way to reward employees and advisors. When sold, they are typically taxed as capital gains rather than income, making them a compelling alternative to other equity instruments like unapproved options.

Growth shares vs. ordinary shares

Growth shares and ordinary shares serve different purposes in your startup's equity structure. Understanding these differences is crucial for making informed decisions about your compensation strategy.

• Value creation timing: Ordinary shares hold immediate market value from the moment they are issued. In contrast, growth shares gain value only when your company's valuation exceeds the predetermined hurdle rate.
• Risk and reward alignment: Growth shares directly incentivize employees to contribute to company growth, aligning employee rewards closely with future business outcomes. This differs from ordinary shares, which provide immediate equity ownership and dividend rights without performance conditions.
• Dilution management: Issuing ordinary shares can immediately dilute existing shareholders. Growth shares minimize early-stage dilution because they have negligible initial value, becoming meaningful only upon substantial company growth.
• Tax advantages: Growth shares often offer favorable capital gains tax treatment upon disposal. Ordinary shares may involve more immediate income tax liabilities depending on their valuation at issuance.

Let's consider an example here. Suppose your startup is currently valued at $5 million. You issue growth shares to a key employee with a $7 million hurdle. If the company is later sold for $15 million, this employee will only benefit from the $8 million increase in value above the hurdle. If they held ordinary shares, their stake would be worth a portion of the full $15 million, but they might have faced a higher tax bill initially.

Growth shares vs. stock options

While both growth shares and stock options are equity incentives, they differ in several key aspects that can impact your startup's compensation strategy.

• Direct Ownership vs. Right to Buy: Growth shares grant your employees actual ownership in the company from the outset, with the value contingent on future growth. Stock options, however, give employees the right to purchase a certain number of shares at a predetermined purchase price (the strike price) at a later date.   
• Administrative Complexity: Growth shares generally involve a more straightforward administrative process compared to stock option schemes. Setting up and managing option plans can involve intricate legal and tax basis, whereas issuing growth shares is often a more direct process. 
• Exercise Requirement: With stock options, your employees need to actively exercise their options (i.e., pay the strike price) to become shareholders. Growth shareholders are shareholders from day one, simplifying the path to realizing the value of their equity if the company performs well.   
• Perceived Value and Motivation: As growth shares represent actual ownership (even if subject to a hurdle), they can sometimes be perceived as more tangible and motivating for employees compared to the future right to purchase shares offered by options.

When should companies use growth shares?

Growth shares are most effective when a company wants to reward key individuals for future performance without touching the value already built by founders or existing investors. Here are the scenarios where they make the most sense:

1. Attracting executive talent on a tight budget: Early-stage companies competing for senior talent rarely have the cash to match corporate salaries. Growth shares bridge this gap by offering executives a compelling stake in the company's future, one that becomes valuable only if they help deliver the growth, they were hired to create.

2. Keeping critical people for the long term: Growth shares can be structured with vesting schedules and leaver provisions that tie full ownership to continued tenure or the achievement of specific milestones. This makes them a powerful retention tool, ensuring key contributors remain invested, literally and figuratively, in the company's trajectory.

3. Building toward a future exit: For companies working toward an acquisition or IPO, growth shares ensure that the people responsible for getting the business there have a direct financial stake in the outcome. Management participation in exit value creates alignment between those running the business and those who own it.

4. Meeting investor expectations post-fundraise: External investors, particularly private equity and venture capital, often require management to have meaningful skin in the game after an investment round. Growth shares satisfy this expectation by giving management a share in future upside without eroding the value that existed at the time of investment.

How growth shares work in practice?

When you decide to issue growth shares, you create a distinct class of equity within with specific rights tied to the future growth of your company. Here are the key steps involved in this process:

Setting the hurdle price

The hurdle price for your growth shares is a critical element that needs careful consideration. Typically, it is based on a professional valuation of your company at the time of issuance to determine the market value of the shares. You might use methods like market analysis of comparable companies, discounted cash flow projections, or seek a formal valuation from an independent firm. 

The hurdle price plays a vital role in ensuring fairness to both existing shareholders and holders of new growth shares. It aligns expectations by clearly defining the point at which the incentive kicks in. Setting an appropriate hurdle is essential; if it is too high, it might demotivate employees, but if it is too low, it could dilute existing shareholders prematurely.

Vesting schedules and conditions

Vesting schedules for growth shares are designed to encourage long-term commitment from your team. A typical cliff vesting schedule might look like this:

• One-year cliff: No shares vest for the first year of employment.
• Four-year vesting period: After the cliff, shares vest monthly or quarterly over the next three years.

For example, if you grant an employee 1,000 growth shares:

• After 1 year: 250 shares vest
• Years 2-4: Approximately 20-21 shares vest each month

Vesting conditions often include continuous employment and can integrate specific performance milestones. These conditions help you retain essential talent and ensure recipients remain actively engaged and aligned with your startup's long-term strategic objectives.

Realizing value from growth shares

Employees realize value from growth shares primarily when your company experiences a significant liquidity event, such as an IPO or an acquisition. Consider a scenario where your startup is acquired for $50 million, and the hurdle price for the growth shares was set at $20 million. 

In this scenario, the value created above the hurdle is $30 million ($50 million - $20 million). The holders of the growth shares would then be entitled to their pro rata share of the $30 million, according to the percentage of the total growth shares they hold. If, however, the exit valuation remains below $20 million, these growth shares yield no payout, emphasizing performance-based rewards.

Benefits of growth shares for startups and employees

Growth shares offer compelling advantages for both startups and employees, creating a win-win scenario that fosters company growth and individual success.

• Customizable performance metrics: Unlike traditional equity, you can tailor growth shares to specific company milestones or KPIs. This allows you to incentivize employees based on metrics most crucial to your startup's success, whether it is customer acquisition, product development, or market expansion.
• Succession planning tool: Growth shares can play a strategic role in your company's succession planning. By gradually transferring ownership through growth shares, you can groom future leaders and ensure a smooth transition of control over time, maintaining continuity in your startup's vision and culture.
• Risk mitigation for investors: For your investors, growth shares can act as a risk mitigation tool. By setting appropriate hurdle rates, you ensure that new equity participants only benefit from future growth, preserving the value of early investments and potentially making your startup more attractive to venture capital.
• Flexibility in granting equity to non-employees: While traditional stock options might have restrictions on who can receive them (e.g., employees only), growth shares often offer greater flexibility. You can potentially use them to incentivize advisors, consultants, or key partners who contribute significantly to your growth but are not on the payroll.

Challenges and risks of growth shares

While growth shares offer numerous benefits, it is crucial to understand the potential drawbacks to make informed decisions for your startup. 

• Risk of no value if hurdles are not exceeded: Growth shares carry an inherent risk for employees. If your company fails to meet predetermined performance benchmarks, these shares may not accrue any value. This potential downside highlights the importance of setting realistic growth targets and communicating them clearly to your team.
• Complexity in valuation: Accurately valuing growth shares can be challenging due to their unique structure. The process often requires complex valuation models and consideration of various market factors. This complexity can lead to uncertainty for both your startup and employees when assessing the true worth of the equity.
• Potential tax implications: Improper structuring of growth shares can result in unexpected tax consequences for your company and employees. Without careful planning and expert guidance, you may face complex tax liabilities that could negate some of the intended benefits of offering this form of equity compensation.
• Liquidity and exit strategy concerns: Growth shares typically lack immediate liquidity, which can be a drawback for employees seeking more readily accessible compensation. The value of these shares often remains unrealized until a significant exit event occurs, such as an acquisition or IPO.  This lack of immediate liquidity can be a concern for employees, especially if an exit is not on the near horizon.

Tax implications of growth shares

Growth shares offer several tax benefits, making them an attractive option for both your company and your employees. Growth shareholders may face a tax liability at two points, when they acquire their shares and when they eventually sell them. The tax treatment at each stage depends on the hurdle rate, the price paid for the shares, and the individual's personal tax circumstances.

Acquisition of the shares

When you issue growth shares, your employees generally will not face an immediate income tax liability because their initial Fair Market Value (FMV) is often low due to the hurdle. This is a key advantage compared to receiving ordinary shares, which are taxed as ordinary income based on their full market value at grant.

Sale of the shares

The primary tax event for growth shares occurs upon a liquidity event, like an acquisition or IPO, when the value exceeds the hurdle. The gain your employees realize at this point is typically taxed as capital gains. For assets held for more than one year, the long-term capital gains tax rates currently range from 0% to 20%, depending on the individual's taxable income. This is often significantly lower than the ordinary income tax rates, which can go up to 37%. This potential for a lower tax burden on the significant appreciation is a major attraction of growth shares.

Conclusion

Growth shares are ultimately a commitment mechanism; they work best when both the founder and the recipient genuinely believe in the company's trajectory. Setting the right hurdle, structuring shares correctly from the outset, and pairing them with transparent communication are what separate schemes that motivate from those that erode trust when expectations aren't met.

If you're considering implementing a growth share scheme, the decisions you make at the point of issuance, valuation, hurdle rate, vesting conditions, and legal structuring, will determine whether the scheme delivers its intended value. Getting those fundamentals right from day one is what makes the difference.

Unlocking progress with growth shares and Qapita

Growth shares offer a powerful mechanism to fuel your startup's journey by directly incentivizing your team based on achieving significant milestones. Their unique structure aligns the interests of your employees with your ambitious growth objectives. It helps develop a culture of ownership and rewards them for the value they help create above a predetermined threshold.

At Qapita, we provide a comprehensive equity management platform specifically designed to simplify the complexities of managing growth shares for startups. Our solution streamlines the entire process, from the initial grant and cap table management to tracking vesting schedules and modeling potential exit scenarios.  We have helped over 2,400 companies and 350,000 employee-owners navigate their equity journey. 

Our expertise in equity management, combined with our user-friendly platform, enables you to focus on growing your business while we handle the complexities of equity administration. Book a demo today and discover how we can support your startup's growth journey.

FAQs on growth shares

How can growth shares be used?

Growth shares are a flexible equity tool that can serve multiple commercial objectives. They are most commonly used as exit-based incentives, rewarding employees when the company's valuation exceeds the hurdle at a liquidity event. Beyond employee compensation, growth shares can also be issued to advisors, consultants, and key partners who contribute to company growth without being on the payroll. They can operate alongside other equity schemes, making them a versatile addition to any equity compensation strategy.

Which employees are eligible for growth shares?

There are no fixed eligibility rules for growth shares, companies have full discretion over who receives them. In practice, they are most commonly issued to senior employees, executives, and directors whose roles directly influence company growth and valuation. Given the investment risk involved and the complexity of the structure, growth shares tend to be most suitable for individuals who have a clear understanding of equity and long-term value creation.

What is a hurdle rate for growth shares?

The hurdle rate is the minimum company valuation that must be exceeded before growth shares carry any financial value. It is typically set at a premium of 10–40% above the company's current market value at the time of issuance. This threshold ensures that existing shareholders retain the value they have already built, while growth shareholders only benefit from future appreciation above that point.

What happens to growth shares if the company doesn't hit the hurdle?

If the company's valuation at exit falls below the hurdle rate, growth shares yield no financial return. They effectively lapse without value since the threshold for participation has not been met. This is an inherent risk of the scheme and underscores the importance of setting a realistic hurdle rate at the outset, one that is ambitious enough to protect existing shareholders but achievable enough to remain a credible incentive for recipients.