Growth shares accounting for UK startups: valuation, IFRS 2 impact, cap table compliance

Understanding Growth Shares Accounting in the UK

For UK startups, particularly in sectors like SaaS or Deeptech, attracting top talent is a constant battle fought with limited cash. Employee share schemes are a powerful solution, and growth shares, also known as hurdle shares or sweet equity, have become a popular and tax-efficient tool. They align employee incentives with future growth without diluting early founders excessively or creating immediate tax burdens for the team. This guide explains how to account for growth shares in a UK startup, from valuation to compliance.

However, while strategically powerful, growth shares introduce financial complexities that often catch founders off guard. Managing the valuation, accounting treatment, and compliance correctly from day one is essential for a clean cap table and a smooth path to future funding rounds. Getting it wrong can lead to unexpected tax liabilities for your team, a messy P&L for investors, and significant compliance headaches. This guide provides a pragmatic walkthrough of the entire process.

What Are Growth Shares? A Foundational Overview

Growth shares are a special class of shares created specifically for employees or advisors. Unlike ordinary shares, they only gain value once the company’s valuation surpasses a pre-agreed threshold, known as the 'hurdle'. This hurdle is typically set slightly above the company’s current valuation at the time the shares are issued, ensuring that holders are rewarded only for future growth they help create.

For example, consider a biotech startup that has just raised a seed round at a £5 million valuation. It might issue growth shares with a hurdle of £6 million. The employees holding these shares only participate in the value created *above* that £6 million mark. If the company is later acquired for £10 million, the growth shareholders participate in the £4 million of value created above the hurdle, while ordinary shareholders participate in the full £10 million.

The primary driver for their popularity is tax efficiency. A key fact is that gains from correctly structured growth shares are treated as Capital Gains Tax (CGT). This benefit is significant, as CGT rates are 10/20%, compared to Income Tax rates of ~45%. However, this favourable tax treatment is not automatic. To comply with HMRC requirements, employees must pay the Fair Market Value (FMV), also known as Actual Market Value (AMV), for the shares at the time they are granted. This brings us to the first major challenge: determining that value.

Challenge 1: The Valuation Puzzle and How to Account for Growth Shares

Accurately valuing growth shares is crucial to satisfy both your team and HMRC. Because their value is tied to a future hurdle, their AMV at the time of issue is very low, but it is not zero. You must establish and document a credible valuation. If HMRC believes the shares were issued for less than their AMV, they can classify the discount as a benefit-in-kind, which would trigger income tax and National Insurance contributions for the employee.

The method for determining AMV often depends on the startup's stage. A crucial distinction emerges between a pre-revenue startup and one that has just closed a priced funding round.

Board Minute Valuation

For very early-stage, pre-revenue startups without a recent priced investment round, a valuation determined by the board of directors can be sufficient. This method is low-cost and fast, but it relies on the board's judgement and robust documentation. The board minute should contain a detailed rationale, referencing business progress, market conditions, and any relevant financial data to justify a low AMV. It is less defensible under scrutiny, so the reasoning must be sound.

Formal Advisor Valuation

Once a company raises a priced round (like a seed or Series A round), a formal, independent valuation becomes necessary. This is highly defensible for HMRC and auditors, as it provides a robust report from a qualified third party. While it can be more expensive (£3,000-£10,000+) and take time, it provides certainty. Valuers often use option pricing models like the Black-Scholes model to determine the AMV, considering factors like the hurdle, company volatility, and time to a likely exit.

The practical consequence tends to be that founders need to match their valuation approach to their company’s maturity. While a detailed board resolution might work for a two-person deeptech venture, a 50-person SaaS company that just raised £10 million needs a formal report. It is also useful to understand practices in other regions. For instance, US-based entities often use a 409A valuation, which can be referenced for UK valuation purposes if applicable, as per US IRC Section 409A. This shows an established international precedent for formal, third-party share valuation.

Challenge 2: The P&L Impact of Sweet Equity Accounting (IFRS 2)

Once valued and issued, growth shares have a direct impact on your financial statements that can surprise unprepared founders. This is driven by accounting standards, specifically IFRS 2, which covers share-based payments. In the UK, the relevant standard is FRS 102 Section 26, which is very similar. The core rule is that share-based payments must be accounted for under IFRS 2.

This standard requires you to recognise the "fair value" of the employee equity grant as an expense on your Profit and Loss (P&L) statement. This is a non-cash expense, meaning no money leaves your bank account, but it reduces your reported profit. For a startup focused on runway and demonstrating a path to profitability, this new expense line item can be significant. The "fair value" for accounting is different from the AMV paid by the employee; it represents the total value of the grant and is calculated using an option pricing model.

This expense must be recognised over the vesting period of the shares. Most startups use a 4-year vesting schedule with a 1-year cliff, meaning the total value of the grant is spread evenly over those four years. For example, if a grant has a total fair value of £48,000 and vests over four years, you must recognise a £12,000 expense each year (£1,000 per month). You can find more details in our IFRS 2 guide or in the FRS 102 guidance available from the ICAEW.

The accounting entry in your system, such as Xero, is a debit to the P&L (creating the expense) and a credit to a new equity account on your balance sheet, often called a 'Share-Based Payment Reserve'. This correctly reflects that you have compensated employees with equity rather than cash.

Challenge 3: Cap Table Management and Compliance

Issuing growth shares creates a new class of equity, which adds another layer of complexity to your capitalization table. For early-stage companies managing their cap table on a spreadsheet, this can quickly become unwieldy and error-prone. Maintaining real-time visibility is essential for investor reporting, due diligence, and understanding founder equity dilution.

Investors will scrutinise your cap table to understand the ownership structure, the size of the employee option pool, and whether all share issuances have been correctly documented. Any discrepancies can slow down or even jeopardise a funding round. A messy cap table signals poor governance and creates uncertainty about who owns what, a major red flag for potential investors.

Beyond the cap table, there is a key legal compliance step. In the UK, issuing new shares requires filing an SH01 form with Companies House, according to Companies House regulations. This form, known as a 'Return of allotment of shares', details the new shares issued and must be filed within one month. Failing to do so is an offence and creates compliance issues that will be flagged during due diligence.

As a startup grows, the administrative load of tracking vesting schedules, leavers, and new grants for dozens of employees makes a spreadsheet untenable. This is the point where dedicated cap table platforms like Capdesk, Ledgy, or Carta become invaluable. They automate the tracking, ensure compliance, and provide a single source of truth for all stakeholders. They also reduce legal and accounting friction during fundraising. If you use Carta, you can explore our integration guide.

The Startup Growth Share Lifecycle: An Actionable Checklist

Navigating the process can be broken down into a clear lifecycle. Here is an actionable checklist for UK startups on how to account for growth shares in a UK startup and implement a scheme.

1. Design and Approval: Work with legal advisors to amend your company's Articles of Association to create the new class of growth shares. The board must pass a resolution to approve the scheme, defining the rules, eligibility, and the hurdle valuation.
2. Valuation: Formally determine the Actual Market Value (AMV) of the growth shares. For a pre-seed company, this might be documented in a detailed board minute. For a post-seed or Series A company, engage a third-party advisor for a formal valuation report to provide a defensible figure for HMRC.
3. Granting Shares: Provide each employee with a clear grant agreement. This legal document should outline the number of shares, the hurdle, the price to be paid (the AMV), and the full vesting schedule, including cliff periods and what happens upon leaving the company.
4. Accounting Setup: Calculate the total IFRS 2 fair value of the grant using an appropriate model. In your accounting system like Xero, set up a recurring manual journal to post the monthly or quarterly share-based payment expense to your P&L and the corresponding credit to your equity reserve.
5. Companies House Filing: Once the employee pays for their shares and they are formally issued, you must file the SH01 form with Companies House within one month. This is a mandatory legal step.
6. Ongoing Management: Update your cap table to reflect the new shareholders and share class. Continuously track vesting schedules and update your IFRS 2 expense calculations if an employee leaves and forfeits unvested shares, as this will require an adjustment to the recognised expense.

Key Takeaways for Founders

Implementing growth shares is a powerful way to incentivise your team, but it requires a disciplined approach to finance and administration. The three core challenges of valuation, P&L accounting, and cap table compliance are entirely manageable with foresight.

Your primary takeaway should be to formalise the process from the very beginning. Document your valuation rationale meticulously, whether in a board minute or a formal report. This documentation is your primary defence against future challenges from HMRC and provides clarity for auditors.

Second, understand that share schemes have a real, non-cash impact on your P&L. Model this IFRS 2 expense so you can explain it to your board and investors. It is a standard part of a scaling company's financial story and should be presented as a strategic investment in talent, not a sign of poor financial performance.

Finally, recognise the limits of spreadsheets. If you plan to offer equity widely, invest in a cap table platform early. The cost is minor compared to the time and legal fees required to clean up a messy cap table during a future funding round or audit. For broader context, see our Stock Option Accounting hub.

What founders find actually works is treating equity administration with the same seriousness as cash management. By addressing these challenges proactively, you can ensure your growth share scheme remains a powerful asset for attracting talent, not a source of future financial and legal friction.

Frequently Asked Questions

Q: What is the difference between growth shares and EMI options?
A: Growth shares are actual shares issued upfront, with value conditional on a hurdle. EMI options are tax-advantaged rights to buy shares in the future at a fixed price. EMI schemes have strict HMRC criteria on company size and industry, so growth shares are often used by companies that do not qualify for EMI.

Q: How does the hurdle for growth shares get set?
A: The hurdle is typically set 10-20% above the company's current valuation at the time of issue. This ensures employees are rewarded for future growth they help create. The valuation itself should be determined either by a recent funding round, a formal valuation, or a well-documented board resolution.

Q: Do growth shares dilute existing shareholders?
A: Yes, like any new share issuance, growth shares cause dilution. However, because they only participate in value above a hurdle, the dilutive effect on the company's current value is minimal. The dilution is primarily felt in a future high-growth exit scenario, which is the intended incentive for all shareholders.

Q: What happens if an employee with growth shares leaves the company?
A: The treatment of a leaver's shares is defined in the company's Articles of Association and the grant agreement. Typically, unvested shares are forfeited. Vested shares may be subject to "leaver provisions," which could force the employee to sell them back to the company, often at the lower of fair market value or the price paid.