Freeze and new share issue strategy

As part of our series of articles on employee profit-sharing and taxable benefit plans, the following article will focus on the freeze and new share issue strategy that a company may decide to implement for its employees.

In fact, freezing shares and issuing new shares is just one of the many ways of involving employees in the company.
Each plan has its own characteristics, and can be adapted to a greater or lesser extent depending on the objectives of the company and its employees.

We’ll take a look at the main features of this type of plan, its advantages and disadvantages, and how it works from a tax point of view.

In the current climate, where retaining key employees has become a major issue for companies, implementing a profit-sharing plan can be a valuable tool for fostering their commitment and motivation.

Concept overview

There are two main stages in setting up a strategy of freezing shares and then issuing new shares.
Here’s the concept.

What is a share freeze?

First, the purpose of the share freeze is to exchange all the shareholder’s common shares for preferred shares.
The value of the preferred shares received at the time of the freeze is a fixed value corresponding to the value of the common shares at the time of the transaction.
In this transaction, 100% of the company’s value at the time of the freeze is therefore attributed to the preferred shares.

From an accounting point of view, freezing shares can have an impact on the company’s financial statements and ratios.
It is therefore crucial to fully understand these implications to avoid any unpleasant surprises.

In terms of tax implications, freezing normally has no immediate tax consequences.
However, it is essential that an appraisal of the company’s value be carried out, to enable deferred taxation.

What does it mean to issue shares?

The second step is to issue new common shares at par value to shareholders in the desired new proportions.

As a result of this transaction, past appreciation will belong to the freezer through the preferred shares, while future appreciation will accumulate in the newly-issued common shares held by the shareholder and the employee.
Preferred shares are entitled to preferential dividends at a pre-determined rate in order to provide a return to the shareholder during the holding period, until such shares are redeemed by the employee or the company in the future.

The broad outlines applicable to the operation of this type of plan

In such a scenario, a shareholder who would like to offer to involve a key employee as a new shareholder of the company could do so in the following way:

1. Valuation of the fair market value of the corporation at the time of the freeze;
2. Freezing of common shares into preferred shares;
3. Subscription to new ordinary shares by the shareholder for a nominal value;
4. Sale of part of the common shares to the key employee for a nominal value;
5. In certain circumstances, and simultaneously with step 4, it may also be possible to sell a portion of the preferred shares held by the principal shareholder to the key employee.

The advantage of this strategy is that it allows the introduction of key employees as new shareholders under less “demanding” financial conditions for the key employee in terms of financing.
Common shares are acquired for a nominal value, while the sale of certain preferred shares can be financed by a balance of sale over a few years (the price is therefore payable from the key employee’s future income) or with the help of a loan from a financial institution (or a combination of both).
In addition, different percentages of common and preferred shares can be sold, depending on the objectives of the “founding” shareholder.

In such a transaction, the shareholder will realize a capital gain when the shares are sold to the key employee, and the shareholder may have little or no tax to pay on the transaction.
The key employee has no tax benefit, capital gains deduction or tax liability in this transaction, since he or she is purchasing shares.

Share buyback

Depending on certain conditions and specific criteria (i.e. the notion of control of the company before and after the freeze; the presence or absence of an agreement concerning the offer to repurchase the preferred shares; the composition of the consideration at the time of the freeze), the preferred shares issued at the time of the freeze will have to be recognized as financial liabilities at the repurchase value or as equity at the value declared in the company’s financial statements.
Such a transaction may therefore have an impact on financial statement presentation and ratios.

Case studies and analysis

Let’s look at a practical example.
Recently, an established company in the business services sector implemented such a reorganization.
The company has been run by its sole shareholder and sole director for over 15 years.
His hard work has enabled the company to build an excellent reputation in its field.
The shareholder is currently in his mid-fifties and, for some years now, has been hoping to reduce his involvement with the company so that he can devote more time to his family and other projects.

In his case, finding the right person to support him in running the business was not an easy process or decision.
However, for two years now, the shareholder has approached and hired an exceptional executive who complements him perfectly.
He sees her as the right person to eventually take over the company.
Wishing to solidify the foundations of this professional relationship, the shareholder decided to present the shareholding project to the key employee, who was very enthusiastic about being entrusted with additional responsibilities and being seen as the company’s successor.

The shareholder therefore wished to implement a strategy involving the issue of common shares to the employee, to demonstrate her important place within the company.
It was determined that the employee could subscribe for 25% of the company’s common shares in the first shareholding phase.
However, the employee did not have the financial means to acquire a significant stake in the company.
The shareholder was therefore hesitating between freezing her shares followed by a new issue at par value, or setting up a stock option program.

However, the stock option program involved a high degree of complexity in setting up the agreement, and the imposition of a significant taxable benefit on the key employee when the shares were acquired.
In addition, the shareholder was convinced of his desire to see this key employee become a shareholder of the company.
In both solutions, it was also necessary to determine the value of the company at the time of the transaction (either for the freezing of the shares, or for the granting of stock options).

In this context and in their case, it seemed simpler and more efficient for the shareholder and the key employee to proceed directly to a freeze of shares followed by a new issue of common shares, and to take advantage of this to have the key employee acquire at the same time common and preferred shares of the initial shareholder in the proportions negotiated between the parties.

This strategy is not without its complexities, however, since the original shareholder now finds himself with a minority co-shareholder, who now holds the rights and privileges attributable to shareholders.
In particular, the shareholder and the key employee must agree on the value of the company for the purposes of the transaction, and enter into a shareholders’ agreement to set out the parameters of their business relationship.

In summary, a share freeze followed by the issue of new shares can be an effective strategy for bringing new shareholders into a company.
It requires strategic thinking to reconcile the objectives of the company, the initial shareholder and the key employee.
Developing such a strategy requires an accurate assessment of the company’s value, as well as a clear understanding of the tax and financial implications. Our tax team can help you implement such a strategy.

Finally, it’s important to remember that freezing shares is not a one-size-fits-all solution.
Each company has its own particularities and ambitions.
So it’s important to analyze the situation carefully before making a decision.