Option schemes, EMIs, ESOPs, when it comes to motivating and retaining talent with shares in your company it can be a bit of a minefield and like many things in business, it’s very easy to get wrong if you don’t know what you’re doing.
This week, we sat down with Laura Peachey, Director at entrepreneurial business lawyers MBM to discuss all things options and what you really need to know.
An option is a right to acquire shares in a company. An option scheme is normally introduced by a company to recruit and retain employees and motivate them to achieve the company’s business objectives. Options are very popular with early-stage growth companies and are used as a tool to help them attract talent from much larger companies.
When you grant an option to an employee, your employee does not have to pay for the grant of the option. The employee only pays for the shares when they exercise their option and become a shareholder of the company. The option agreement will stipulate when the option can be exercised e.g. when certain exercise conditions are met such as remaining an employee of the company for an agreed number of years or on an exit of the company (e.g. a trade sale, share sale or IPO).
There are generally two types of option schemes. An option can either be an Enterprise Management Incentive (EMI) option or a non-qualifying option (which means it does not qualify under EMI rules).
EMI options are more tax-efficient than non-qualifying options and are the “go to” type of option scheme to use in the UK for employee share options. However, there are restrictions on EMI options and therefore it is not always possible for a company to grant EMI options to certain people. An example of one of these restrictions is a company can only grant an EMI option to an employee who works for the company for 25 hours or more each week or 75% of his or her total working time. Most non-executive directors will not qualify for this test and they will often receive non-qualifying options as a result.
For much larger companies, EMI option schemes will not be possible, and they often introduce a different type of option scheme, such as a CSOP scheme. These are generally not as tax efficient or flexible as an EMI share option scheme.
A company is free to decide how big they wish to make their option pool; however, it is important for founders to remember – the bigger the option pool, the more diluted their shareholding will be once the option is exercised. In terms of high growth companies, a 10% option pool is most common although the size of option pools can differ in size depending on the specific circumstances.
You can offer options to as many or as few employees are you want. However, as mentioned above, if you wish to grant EMI options, there are restrictions that apply and therefore it may be the case that not all your employees will qualify for EMI options. Options should generally be reserved for use with senior management and key employee hires who need to be incentivised to join the company or to be retained.
Anytime! If the company has employees it wants to keep hold of and motivate them to achieve the company’s business objectives, we recommend you put an option scheme in place.
Please note that if you are planning to introduce an EMI scheme then you should look to do this ahead of any funding round so that the valuation for the share exercise price can be kept as low as possible.
A low share price will benefit each employee but in the case of EMI Options this price should be agreed in advance with HMRC.
Most companies will adopt an option scheme over ordinary shares. Many high growth companies will have multiple share classes, with VC investors taking preference shares, but the shares for staff under their share options still tend to be granted over ordinary shares. In some cases, options can be granted over a different class of share (eg non-voting ordinary share or specific type of growth or flowering share) but this is less common and specific advice should be taken in relation to any such arrangements.
Investors will often want to make sure that a share option pool is not too generous (e.g. anything over 10% could be viewed as generous) because the exercise of the option in due course will dilute their shareholding. Investors will also want to know that the terms of any option pool are aligned with the future plans of the company. So, if a company is pitching for investment as part of an exit over a 5-year period, then the investors are often going to want to see senior management having a share option package which is aligned with that exit strategy.
As noted above if you are planning to introduce an EMI scheme then you should look to do this ahead of any funding round so that the valuation for the share exercise price can be kept as low as possible. A low share price will benefit each employee but in the case of EMI Options this price should be agreed in advance with HMRC.
A budget of circa £1,500 to £3,000 plus VAT should comfortably cover a standalone, unapproved, option agreement to a detailed EMI option scheme, where the exact price will depend on the complexity of the terms and how much bespoke tailoring is needed. EMI option schemes are more costly to put in place than non-qualifying options, however, as mentioned, they come with excellent tax benefits for employees and therefore are more likely to motivate them.
The main thing to be aware of is that, once an option holder has exercised their option, they are in the same position as any other shareholder of the company. Therefore, if the company does not wish to have employees as minority shareholders, crowding the register of members and making managing the constitutional affairs of the company more burdensome, we would recommend the company makes all option agreements exit only. This means that the employee will not become a shareholder until there is an exit opportunity for all shareholders.
If you do plan to have employee option holders become shareholders before an exit event then it would be wise to review and update your articles of association to put in place separate provisions (e.g. future compulsory transfer provisions for employee leavers, drag along provisions and pre-emption rights) to cater for staff members becoming shareholders and to protect against a future dispute with them.
Please note that the rules for EMI option schemes are set by HMRC and there are specific rules and conditions which must be carefully followed to remain EMI compliant. Please take tax and legal advice in relation to any such scheme set up to ensure that these rules and conditions are followed. Many companies fail to do this and often find that the schemes that they have set up are not compliant.
If you have any queries on the set up of a proposed share option scheme, then please don’t hesitate to get in touch with the Options Team at MBM Commercial. One of our lawyers or tax specialists will be happy to have an initial chat with you for free. Please email OptionsTeam@mbmcommercial.co.uk.
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