Options and Employee Share Schemes

Introduction

Employee share schemes and options are powerful tools for businesses looking to reward and incentivise their workforce. Offering shares or options to employees not only aligns their interests with the long-term success of the company, but can also serve as an attractive retention strategy. Whether it's through tax-advantaged Enterprise Management Incentive (EMI) schemes or more flexible Unapproved options, these initiatives provide companies with tailored ways to engage their teams. This guide explores the differences between shares and options, dives deep into EMI and Unapproved schemes and explains essential concepts like unallocated options and how to manage leavers, helping businesses design effective and sustainable share-based incentives.

Contents:

1. What is an Option
2. Shares vs Options
3. Employee Share Schemes
4. EMI vs Unapproved
5. Unallocated Options
6. Departing Option Holders
7. Final Thoughts

What is an Option?

A share option refers to a type of financial incentive often used to reward employees, founders, or investors. A share option gives the recipient the right, but not the obligation, to purchase company shares at a pre-set price (known as the "exercise" or "strike” price) after a certain period and/or when specific conditions are met. These share options are taken from an option pool, which typically represents 10-20% of the company’s total equity. Share options that are not allocated from this option pool are known as ‘Unallocated Options’.

Shares vs Options

You can give people ​actual shares​ now, or choose to issue ​share options​ that can be exercised at some point in the future (becoming shares either then, or at the time of an exit event). Whereas shares represent actual ownership in a company, options give the holder the right (but not the obligation) to buy shares at a set price within a specific time frame. Unlike shares, options do not represent ownership until they are exercised. Here’s a comparison table outlining the key differences between shares and options:

Employee Share Schemes

What is an employee share scheme?

An employee share scheme is a way of sharing company ownership with your team. You can reward one or more key people with equity, or extend it to all employees – the choice is yours. You can also distribute shares to non-employees, such as consultants or advisors, although it may be better to run different schemes for internal and external people.

Why launch an employee share scheme?

Offering employees a stake in the business, such as through a share scheme, can be beneficial for both the company and its team. While some board members may worry about diluting existing shareholders' stakes, the long-term benefits can outweigh these concerns. Research supports that share schemes not only enhance employee motivation and engagement, but also provide financial benefits to all shareholders.

Introducing a share scheme can help attract and retain top talent by making compensation more competitive and fostering loyalty. Employee shareholders are often more motivated, leading to higher productivity and increased revenue. Additionally, equity incentives can help ease cash flow pressures by reducing the need for higher salaries or bonuses and can provide tax advantages.

Overall, a share scheme can strengthen company culture, reduce staff turnover and add long-term value to the business. Independent advice is available to help make the case for implementing such a scheme. Before proceeding, it's important to understand the differences between EMI and Unapproved options.

EMI vs Unapproved

Enterprise Management Incentive (EMI) schemes and Unapproved option schemes are two key methods companies use to grant share options. EMI schemes are tax-advantaged and specifically designed for smaller businesses, offering significant tax breaks to both employees and employers. On the other hand, Unapproved option schemes are more flexible and can be used by companies of any size, but they do not come with the same tax benefits. Both serve as valuable tools to attract and retain talent by giving employees and (in the case of Unapproved options) other relevant people a stake in the company's success. Here's a quick overview of how each scheme results in slightly different tax implications for employers.

Let’s take a deeper look at EMI and Unapproved option schemes.

EMI Deep Dive

The Basics

EMI schemes grant employees the right to acquire shares in a company under specific terms outlined in an option agreement. This agreement specifies the number of shares, the acquisition price and the conditions for exercise, such as tenure or performance milestones. EMI schemes are designed to incentivise and retain key talent, particularly in trading companies with growth potential.

Qualifying Options

EMI options must meet specific criteria to qualify:

• Shares: Options must be granted over ordinary shares that are fully paid and not redeemable. They can be subject to restrictions, but must be capable of exercise within 10 years.
• Individual Limit: EMI options over shares worth more than £250,000 per individual will not qualify.
• Employee Exclusion: Employees with a 'material interest' exceeding 30% of the company’s share capital before options are granted are excluded from participation.

Employer Benefits

• Tax Advantages: EMI schemes offer significant tax benefits for employers. There are no tax costs incurred, provided certain conditions are met. Additionally, employers can claim corporation tax relief on the difference between the market value of the shares at exercise and the option price paid. This relief can substantially benefit the business and its shareholders, particularly upon a sale.
• National Insurance Contributions (NIC) Relief: Employers are exempt from paying NIC on either the grant or exercise of EMI options, further reducing costs associated with the scheme.
• Recruitment and Retention: EMI schemes serve as a powerful tool for attracting and retaining top talent. Offering ownership stakes aligns employees' interests with the company's success, fostering loyalty and reducing staff turnover. Furthermore, engaged employees are more productive and innovative, driving business growth and competitive advantage.

Qualifying Companies

Companies must meet certain criteria to qualify for EMI schemes:

• Gross Assets: The company's gross assets must not exceed £30 million.
• Employee Count: The company must have fewer than 250 full-time equivalent employees at the time of EMI options grant.
• Trading Status: The company must be actively trading and have permanent premises in the UK. There are some excluded activities, such as banking, farming, provision of legal services, ship building and property investment.
• Independence: The company must be independent, and not controlled by another entity.
• Total EMI Shares: The company cannot allocate more than £3 million in EMI shares.

Employee Benefits

• Tax Efficiency: EMI schemes offer employees lower tax costs compared to cash or non-EMI arrangements. There is no income tax or employees' NIC on either the grant or exercise of options, subject to certain conditions. Capital Gains Tax (CGT) is applied at a reduced rate of 10% on the growth in the value of shares, providing significant tax savings.
• Flexibility: Employees can choose to exercise their right to buy their shares, once all exercise conditions have been satisfied, at any time for up to 10 years. As a result, an employee is given the freedom to choose when to buy, yet the purchase value of these shares will be set out in the initial share option agreement.
• Long-Term Incentives: Participation in an EMI scheme encourages employees to think long-term. Since significant returns often require sustained commitment and company growth, employees are incentivised to stay with the company, reducing turnover costs and ensuring continuity. Furthermore, studies show that employees who have a stake in the company's success are more engaged and committed to achieving shared goals. The potential for a substantial windfall in the form of share appreciation further fuels employee motivation and dedication.

Qualifying Employees

To qualify for EMI options, employees must meet the following criteria:

• Employment Status: Employees must be legally employed by the company or one of its qualifying subsidiaries.
• Working Hours: Employees must work at least 25 hours per week for the company or one of its qualifying subsidiaries or, if less, at least 75% of their total working time must be as an employee or director.
• Shareholding Limit: Employees cannot hold more than 30% of all company shares before the options are granted.

EMI schemes offer a win-win proposition for both companies and employees. Employers benefit from tax advantages and enhanced recruitment and retention capabilities, while employees enjoy tax-efficient incentives, long-term rewards and increased engagement. By embracing EMI schemes, companies can cultivate a motivated workforce poised for sustainable growth and success.

Unapproved Deep Dive

The Basics

At its core, "unapproved" means a scheme that operates outside the purview of HMRC-approved tax breaks. Unapproved schemes are also known as ‘Non-Tax Advantaged’ (NTA) because, unlike schemes such as EMI options, unapproved share options do not enjoy the very best tax advantages accorded by HMRC approval. Instead, they offer companies greater flexibility in structuring incentive packages for their employees.

Essentially, an unapproved share option grants the holder the right to acquire shares at a predetermined price from a future date. This fixed price may mirror the value of the shares at the grant date, incentivising the option holder based on anticipated growth in share value.

Operating Mechanics

Unlike their HMRC-approved counterparts, unapproved share options typically entail tax liabilities upon exercise. Any gains realised from the exercise of these options, defined as the difference between the value of the shares at exercise and the price paid to exercise the option, are subject to income tax and often National Insurance Contributions (NICs). This tax obligation is typically collected under PAYE following option exercise, ensuring compliance with regulatory requirements. However, in scenarios where shares are not readily convertible into cash, triggering only income tax liabilities (and not NICs), employees must declare the gain in a self-assessment tax return for the relevant tax year. This nuanced approach underscores the importance of understanding the tax implications associated with unapproved share options.

Tailored Participation and Limitations

One of the inherent strengths of unapproved share option plans lies in their adaptability to suit company objectives. Employers retain the discretion to select participants, extending the opportunity to any employee or executive director deemed eligible for participation. Unlike HMRC-approved schemes, unapproved plans are not bound by HMRC-imposed limits, offering companies greater flexibility in designing incentive structures tailored to their unique needs and circumstances.

Grant of Options: Setting the Stage

At the heart of an unapproved share option plan lies the grant of options, wherein a specific number of options are offered to an individual. Unlike EMI plans, unapproved schemes offer greater latitude in terms of option quantity, making them an attractive solution for companies seeking to reward employees beyond the constraints of EMI plans. The exercise price, being the price at which the individual can acquire shares, remains a pivotal aspect of the plan, with flexibility to set it at any figure above the nominal value. Crafting a comprehensive legal document to outline the terms of the options is imperative, ensuring clarity and alignment between the company and its employees.

Both EMI and Unapproved option schemes provide businesses with powerful tools to reward and incentivise their employees. While EMI schemes offer attractive tax benefits for eligible companies, Unapproved schemes offer greater flexibility for businesses of any size. Choosing the right scheme depends on the company’s goals, size and growth stage. With the right structure in place, these options can play a critical role in fostering employee loyalty and driving long-term business success. FounderCatalyst can help you implement either EMI or Unapproved option schemes, tailored to your company’s needs.

Here’s a table to compare them:

Let's take a look at how this might work in practice.

Scenario: James and David are both granted options to acquire 1% in their employer's company at its current market value of £5,000. James is granted EMI options, and David is granted Unapproved options. Five years later, when the shares are worth £50,000, they exercise the option. Three years after that, they sell them for £100,000 when the company undergoes an acquisition.

EMI

Because it’s an EMI option, James benefits from favourable tax treatment. He pays no tax when the option is granted, and on exercise, he isn’t treated as having received any taxable income - even though the shares have increased significantly in value since the option was granted.

When James eventually sells the shares, he is liable for capital gains tax only on the increase in value from £5,000 (the option’s exercise price) to £100,000 (the sale price). This is a £95,000 gain, and thanks to EMI tax benefits, this gain is eligible for Entrepreneurs' Relief, which reduces the capital gains tax rate to 10%. Ignoring any additional reliefs, James' capital gains tax liability on the sale is £9,500.

In total, James pays just £9,500 in tax on his gain, and he doesn’t face any tax liabilities until he actually receives cash from the sale. This favourable tax treatment makes EMI options particularly advantageous for employees, minimising tax exposure and providing flexibility in managing the timing of tax payments.

Unapproved

David will pay no tax at the time of his option being granted. However, on exercise, it is deemed that he has received taxable earnings of £45,000 (the £50,000 share value minus the £5,000 option exercise price). Although he hasn't received any cash, he must pay income tax on this amount at his marginal income tax rate - up to £20,250.

When he sells the shares, David is liable for Capital Gains Tax on the additional £50,000 gain since he acquired them. Without applying any reliefs, the CGT would be charged at 24%, resulting in a tax liability of £14,000.

In total, although David has benefited from purchasing shares for £5,000 and ultimately selling them for £100,000, he has paid up to £34,250 in taxes, most of which was payable well before he received any cash. This tax would have been owed regardless of whether the shares’ value had declined or if a sale opportunity had not materialised.

For a step by step guide on how to set up an options scheme on FounderCatalyst, click Options Schemes.

Unallocated Options

There are three main strategies to manage unallocated options:

1. Keep the Option Pool

If the company anticipates needing share options to attract or retain key employees in the future, it may choose to keep the option pool intact. This allows the company to issue new share options as needed, without needing to create a new pool or dilute existing shareholders further.

2. Destroy the Option Pool

If the company no longer sees the need for the option pool, it can remove it. This is typically done with the approval of existing shareholders.

• Timing Considerations: The earlier you remove the option pool, the less dilution the founders will experience in future funding rounds. If you wait until new investors come in, the unallocated pool is treated as part of the company’s fully diluted cap table, increasing the total share count and leading to more dilution. This is because investors expect the pool to be split proportionally across all shareholders.
• No Tax Issues: Destroying the unallocated pool does not trigger any tax consequences, as the options have not been granted.
• Cap Table and Dilution: It’s important to remember that an unallocated option pool doesn’t show up on public records like Companies House, but does exist on the company’s internal cap table. It’s used for "round modelling," and affects dilution calculations. For example, when talking about a fully diluted cap table, the option pool impacts the founders' shareholdings, investor shareholdings and overall company equity structure.

3. Issue the Equity to Founders

Another option is to allocate the unallocated shares directly to the founders. This may trigger tax considerations, and requires approval from existing investors, which may not always be easy to obtain as investors are often reluctant to dilute their own holdings by giving more shares to founders.

Is creating a large unallocated option pool suboptimal?

Founders need to balance the creation of the option pool with their own equity stakes and future fundraising plans. If the option pool is too large, founders face unnecessary dilution, which can hurt their long-term ownership and financial returns.

Here’s why:

Founder Dilution vs. Investor Benefit

Creating a larger-than-needed option pool dilutes the existing shareholders, including founders, right from the start. For example, if a 50% option pool is created, but only 10% of it is actually used, the remaining 40% of equity is unnecessarily removed from the founders’ stake. This means that:

• Founders get diluted for creating the pool, even though those shares are not being allocated immediately.
• Investors benefit later: When the company raises funds, new investors will share the benefit of any unused portion of the option pool. This unfairly disadvantages the founders, who experience dilution upfront but don’t gain the full benefit of the unused options on exit.

The disproportionate benefit to investors and the disadvantage to founders is what makes creating a larger-than-needed option pool suboptimal.

Departing Option Holders

Ordinarily, any employee who holds EMI share options but leaves the business would immediately lose the right to exercise any unexercised options. This can be made subject to Board discretion, in the event of extenuating circumstances. This would also normally be the case for Unapproved options, although as they can be held by people other than employees (e.g. suppliers and advisors) there may be commercial reasons why some or all unexercised options can still be exercised after the services in question cease to be supplied – this is a matter for negotiation when the option terms are finalised.

Final Thoughts...

In summary, employee share schemes and options can be highly effective in motivating and retaining talent, while driving company growth. Whether you opt for an EMI scheme to benefit from tax advantages or an Unapproved option scheme for its flexibility, understanding the mechanics of share options and employee qualification is crucial. By carefully structuring these schemes to fit your company's needs and long-term goals, you can create a culture of ownership and investment among employees. Thoughtful planning around unallocated options can further enhance the success of your share-based incentives. Share vesting, including the good and bad leaver concept, is also crucial – this is the subject of a different article that can be accessed here.