Share options. Definitely a “buzz term” in the startup world. But what exactly are they? And what do you need to do in order to grant share options to members of your team?
My colleague Gretchen Lennon, senior counsel at Ignition Law and a specialist in employment and incentives law, talks us through what share options are all about and the various options you have (no pun intended!) for implementing a share option scheme for your employees.
Shares vs options
For startups and SMEs, equity can be a great way to attract, incentivise and align goals with key employees or directors, while preserving precious cash reserves. Two common ways of achieving this include:
- Transfer or giving of shares – Recipients would legally own shares in your company and become shareholders on your register of members or cap table. Depending on the rights attached to the class of share they get (eg ordinary shares, B shares, etc), recipients would also be immediately entitled to dividends from historic and future profits, voting rights and proceeds from the sale of the business or its shares. The grant of shares may give rise to an immediate tax charge.
- Share options – Used to incentivise, attract, retain and reward employees, a share option is the right (but not the obligation) to acquire a set number of shares at a fixed price at some point in the future, ie an option holder is not automatically a shareholder of the company, but could become a shareholder when they eventually exercise their options.
Remember that giving away equity isn’t the only way to incentivise team members and if there is any way to avoid doing so, it’s certainly better to hold on to as much of the company yourself as you can! For example, think about whether or not you can just offer cash bonuses, such as commission-based bonuses to marketing or sales team members, rather than giving away a portion of your company.
Setting up a share option scheme
So, share options sound like a good idea, what do I do next?
There are, broadly speaking, two types of share scheme that will likely be appropriate for SMEs:
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- Enterprise Management Incentive (EMI) Scheme – Tax-efficient and SME friendly. It is advisable to agree your share price (often heavily discounted) with HMRC in advance, which will help determine the exercise price (or ‘strike price’) of the EMI options. Only available to employees or directors (subject to meeting certain eligibility requirements). Entrepreneur’s relief available on any gain (ie CGT at 10% if options held >12 months) regardless of shareholding.
- Unapproved Share Option Scheme – You can’t agree a valuation in advance with HMRC. Less favourable tax implications for the individual on exercise. Can be available to non-employees and consultants.
Choosing the best approach
If eligible, EMI share option schemes often represent the best approach for SMEs. Regardless, when choosing between gifting and share options, matters to consider include:
- Tax – Implications for the company and the employee. EMI share option schemes are generally much more beneficial for both in this respect.
- Valuation – Ultimately the value of the options or shares is determined by the company. However, HMRC will check that income tax and NICs are not being unduly avoided.
- Flexibility – If your employee/consultant leaves on bad terms, what would you like to see happen to the shares or options? (The lapse of options is usually simpler than trying to claw back shares) And what if they leave on good terms?
- Income or capital – Is the greater share value in receiving dividends from profits (shares may be best) or in a capital gain such as an IPO or business sale (exit-only options may be best)?
- Timing – When should the individual be able to own the shares? What vesting and exercise conditions should you attach to the options?
Adoption of the scheme
Typically, you would need to put the following documentation in place in order to implement a share option scheme:
- Board and shareholder resolutions approving the scheme and the grant of options
- Share Options Plan Rules – a document setting out the general rules that will apply to all options granted under the plan
- Individual Option Award Agreements – setting out details of each individual’s options and any vesting/exercise conditions
- Check any shareholders’ agreement that you may have in place in case other consents/approvals are needed for the grant of options
A couple of other considerations for EMI options:
- You will want to get your accountants involved to agree the valuation with HMRC
- EMI options must be granted within 60 days of agreement of the valuation with HMRC, otherwise the valuation will need to be redone
- Once an EMI option has been granted, notification must be made to HMRC within 92 days from the date of grant (this can be done online)
Regardless of whether you decide that the grant of shares or share options is best for your team, it is crucial that the terms applicable to the shares or options are properly documented. It can be much more difficult to claw back shares, or lapse options when detailed vesting or leaver provisions have not been set out in writing.