In certain cases companies grant their employees the right to acquire shares at a predetermined price. This granted right is widely used by start-ups and young companies to attract future workers, as well as to retain employees and motivate them in their positions. As far as we deal with quite a common phenomenon, this article is devoted to a comprehensive overview of how share option plans work and what are the key considerations in granting options in the UK.
What are the share options?
Roughly speaking, a share option corresponds to one`s right to acquire a predetermined number of shares at an agreed price under certain criteria, for instance, an employee’s obligation to sign a five-year contract. The exercise price is set at the market value of the shares, or slightly below it, so the employee when exercising his/her option, can recognize significant gain.
EMI share option and the tax advantages
Enterprise Management Incentive (EMI) suits small companies. This initiative of EMI options is favorable for tax treatment for both parties, employers and employees. Generally speaking, there is no tax for the employee upon grant, vesting, or exercise, while employers receive tax rebates when options are exercised. Thus, EMI schemes can help start-ups and SMEs attract and retain talent through equity-based incentives while optimizing taxes.
Setting up a share option program
To grant share options in the UK, there are a few basic requirements that need to be met: the rules of the share option plan must be defined and the options legally formalized through signed contracts between the employee and the employer. An HMRC-approved EMI scheme is optimal for favorable tax benefits but needs to be formally registered within the required timeframe. Accurate records must be kept of all option grants, as well as vesting schedules, eligible employees, and exercises. The company’s articles of association must allow for the allocation of new shares against exercised options. Sufficient ordinary share capital must be maintained to allow for the exercise of options.
Stock options typically vest gradually over 2-5 years to encourage employee retention and productivity. Typical structures grant 25% of the total number of options granted after 12 months and then a set percentage on a monthly or quarterly basis. Various vesting conditions can be set – most commonly continued employment, as well as the achievement of individual or company goals. Options generally lapse if employees leave the company before full vesting.
Setting the exercise price
The exercise price fixes the purchase price that option holders pay for a share upon exercise of their right. The exercise price cannot legally be significantly lower than the market value of the shares at the time of grant, but can sometimes include a modest discount to incentivize employees. Other common approaches are to set the price based on the nominal value of the share or the most recent valuation of a financing round. The exercise price is fixed on the date of grant, even if the actual value of the shares increases later.
Terms and expiry date
Although options vest over specified periods in accordance with the terms and conditions, the vested rights are generally exercisable at any time during the later vesting period, typically 7-10 years from the date of grant. Options not exercised during the vesting period become worthless. Companies may also require options to be exercised over a shorter period of time after employees leave the company. Appropriate expiry periods and post-employment training windows should encourage retention whenever possible.
Share dilution and the impact of the restriction table
Issuing large option pools can significantly dilute existing founders/investors after exercise. Typically, 10-15% of the total number of shares in the table is reasonable for employee option pools, but the optimal size depends on hiring plans, existing shareholdings, and the desired return of the founder/investor. It is important to accurately model the potential dilution over time and to maintain reserved unissued share capital for the exercise of vested options.
Managing share option schemes involves ongoing administrative work, long-term record-keeping, and compliance, from issuance to eventual exercise and distribution of shares. Companies need to keep track of active and lapsed grants, vesting stages, eligible employees, and those who leave. Expert guidance ensures that option terms, tax returns, share allocations, company charters, and documents are compliant with UK regulations. Although cumbersome, proper management at an early stage reduces costly mistakes. In this respect, ERB is at your service, ready to provide consulting and support in all your option-granting activities. Contact us today, and we will be glad to provide you with personal guidance on the option programs suiting specifically your business case.