Sweat equity is normally defined as ‘unpaid labour’ that an employee, entrepreneur or investor puts into a business in order to build it up while cash resources are limited, in the hope that they will be rewarded via a long-term increase in the value of equity in the business.
However, the warm glow of success when that unpaid labour contributes to the building of a valuable business can also lead to a certain level of anxious perspiration if the tax issues that arise from sweat equity have not been properly considered and addressed.
Where an employee or an officer of a company is rewarded or incentivised by the allocation of shares or options in the company, there are detailed (some would argue ‘complex’) tax rules dealing with ‘Employment Related Securities’ that regulate how those arrangements need to be taxed.
Much has been written about those rules and some of the complexities and choices that arise for a company offering ‘equity’ based compensation to employees, but there is little to no guidance on how to treat equity allocated to contractors who have no employer/employee relationship with the company, and to whom the ERS rules do not apply.
As advisers we see an increasing number of smaller, entrepreneurial businesses, either genuine start-ups or businesses in their second phase of development, using sweat equity to bring in expertise that they simply couldn’t afford if they had to pay cash for the services provided.
For example, Ms A and Ms B set up a new company to try and build a business from a Big Idea that they have had in the pub one evening and set up Big Idea Co Ltd, owning 50% of the shares each. Both Ms A and Ms B recognise that they will need some cash to develop Big Idea, so they each invest £50k to acquire their equity stake.
Although Ms A and Ms B are great at developing the technology needed for Big Idea, they will be the first to admit that that they aren’t experienced in running a commercial business or raising the money needed to take Big Idea to the market. Luckily though, they have a contact, Ms C, who has lots of experience in raising money for start-up companies and can help to convert Big Idea into ‘Big Sales’. The only problem is that Ms C’s time costs a lot of money, and Big Idea Co is clean out of cash.
To bridge the gap, Ms C is appointed as a consultant to Big Idea Co and agrees to work for no compensation but in return, it is agreed that Ms C will be rewarded with new shares in the company. The terms of the arrangement are that Ms C is entitled to receive new shares equivalent to 5% of the company on agreeing to act as consultant, and a further 5% if Ms C successfully raises external equity funding of £1m.
Twelve months pass and Big Idea is now fully developed. Ms C has also been successful in putting together business plans and finding investors and as a result, has not only raised £1m but has persuaded investors that the value of the company is £5m, so the Company has raised new equity at that £5m valuation.
Ms C mentions to her accountant that she is about to be issued with shares for her agreed 10% stake in the company but “there is no tax to worry about as I haven’t received any cash”. The Company also tells its accountants that no action is required since Ms C won’t be paying for her shares. At this point the two accountants start to sweat, but without the equity!
Tax and other implications
In our day-to-day advice it is often helpful to go back to first principles and in this case, it is imperative because, as noted above, there is no specific tax legislation that deals with this situation. However, the consequences are logical if you follow the correct equity issuance and accounting principles.
With all new issues of equity, a company has to send a form (SH01) to Companies House notifying the number of shares issued and the consideration received for those shares. Where there is non-cash consideration, the nature and value of that consideration must be stated on the form. So in this case, Big Idea Co has to put a value on the service it has received from Ms C and that value is registered at Companies House.
When new shares are issued for non-cash consideration, the company shows the equity as having been issued for the value of that non-cash consideration, ie Credit Share Capital with £x. Since no cash has been received, the company needs to book a corresponding debit, in this case Debit P&L for Consultancy Services £X.
Since Big Idea Co has booked an expense item for Consultancy Services, it may be able to obtain a corporate tax deduction for the P&L cost of those services, even though they were not paid for in cash, subject to the services satisfying the normal deductibility rules.
That all seems quite straightforward for the company but what about Ms C? Ms C has provided a service and received valuable consideration in the form of 10% of Big Idea Co and her accountant tells her that the value she has received is subject to income tax. Ms C is not at all happy to hear this news because although she has just received some valuable shares, she has zero cash and is also unlikely to be able to sell any of the shares in order to pay a hefty tax bill.
Ms C did not anticipate this cash flow issue when she signed up to receive payment for her services in equity. But that’s not Ms C’s only worry.
In addition to income tax, she will also be liable to pay Class 4 NICs on the value she has received, again with no cash coming in to cover the cost.
And what about VAT? Consultancy services would potentially be subject to VAT and as Ms C is likely to be above the VAT registration threshold, she may need to charge VAT to Big Idea Co depending on the nature of the services supplied. In this case the services may well be exempt or partially exempt, but if Ms C submits a large and unexpected VAT invoice to Big Idea Co, this could cause cash flow problems for the company and friction between the parties.
Then there is the value of services vs value of consideration received. Before our perspiring accountant can calculate exactly how much Ms C might owe to HMRC, it is necessary to attribute a real world value to the services provided, as it is this value that drives the accounting for Big Idea Co and also the personal tax and associated consequences for Ms C.
Is the value received always the same as the value of the service?
Ms C’s case gives us a good illustration of the valuation issues arising from sweat equity arrangements. In her contract, Ms C is entitled to receive 5% of the company for acting as consultant irrespective of whether Big Idea Co is a success or not. That entitlement arises when she signs the contract, even though the shares are not ultimately issued to her until 12 months later. At the time the contract was signed, the company was probably worth no more than the £100k invested by Ms A and Ms B (meaning that Ms C’s 5% would only have been worth £5k). However, when the shares were finally issued, the company was worth £5m (at which point Ms C’s 5% holding was worth £250k). That’s quite a difference particularly when you look at the tax implications for Ms C.
Given that she has absolute entitlement to 5% from day 1, the value attributed to the services should follow the value of the agreed consideration at the point of “entitlement”. In an ideal world, Ms C would have issued an invoice at or close to that date but in any event, provided ‘entitlement’ is clear from the contract, that should fix the valuation date.
This is consistent with the idea that the remuneration is driven by the value of the services, not the value of the consideration that is ultimately delivered. Big Idea Co, with £100k in the bank, would never have committed to pay the equivalent of £250k for Consultancy Services.
Could this be clearer?
If you have the luxury of planning ahead and considering these issues before agreements are signed, the cleanest ways to deal with this issue is to allocate a cash value to the service on day 1. So in this case, the contract would say that Big Idea Co agrees to pay a consultancy fee of £5k, but that both parties agree that the fee will be settled by the issuance of shares equal to 5% of the company.
Ms C was also entitled to a further 5% of the company if she successfully raised finance of £1m. As this 5% was completely conditional on satisfaction of certain future criteria, no “day 1” entitlement arose. In this case, Ms C becomes entitled to the other 5% shareholding at the point when the external finance has been raised and is sitting in Big Idea Co’s bank account. Because the Company is then worth £5m, this sets the value of Ms C’s fundraising services (and her other 5% shareholding) at £250k.
This obviously leaves Ms C with a sizeable tax bill and some admin headaches. On the flip side, Big Idea Co potentially has a corporate tax deduction of £250k.
What are the alternatives?
There are no clever planning techniques to avoid the issues raised above. However, by ensuring that advisers are aware of the potential pitfalls relating to sweat equity they can take steps to try and ‘fix’ valuation points at the most appropriate time and value.
For consultants such as Ms C, it is important to plan for potential liabilities and also to discuss with the company the potential need for a split of cash and equity consideration so that there is enough cash to cover any tax liability (and to do this before signing the contract)!
For anybody looking at this situation after contracts have been signed, it is worth spending some time analysing the contracts and looking at other factors that might impact the valuation of any equity entitlements …. the problem might not be as big as you think. For example, a minority stake in a company would rank pari passu in valuation terms if there is a watertight shareholders agreement in place but absent a shareholders agreement, even if the company itself is very valuable, a minority stake with very limited influence would attract a very large discount if sold to an independent third party.