Glasgow Tech Week - understanding share options

Share options give a third party such as an employee or director (known as an option holder), a right to acquire shares in a company at a previously agreed price, at some point in the future provided certain criteria are met or certain events occur.

Why do companies use share options?

The key reasons for share options are typically financial and motivational. Share options are one way of incentivising your staff financially without the cost of bonuses. Employee share incentive plans can be a tax-efficient way to remunerate employees. However, there are more advantages than just the tax benefits. If the terms include a performance target, this may encourage better employee performance. If the terms include specific employment periods, this may encourage loyalty and retainment of employees. They can help to reduce employment costs and to recruit, retain and motivate employees, and improve staff performance. Share incentives can also help to align the interests of senior executives with those of shareholders by encouraging them to consider shareholders’ interests in managing the business. They can also help private companies with succession or exit planning.

Options can be either approved (tax-favoured) or unapproved (non-tax-favoured). The benefit of unapproved option plans is that they can be very flexible – there are no statutory provisions governing their terms. However, they do not attract any tax benefits. There are many types of share options which attract favourable tax treatment. The most common for early-stage businesses are Enterprise Management Incentive (EMI) share options which are specifically targeted at relatively small, higher-risk trading companies.

How or when the option holder owns the shares is up to the company. For example, staff may be given the full option at the outset, or the option may ‘vest’ over time, meaning each year they get a certain number providing they meet the conditions agreed i.e. time served in the company or hitting certain performance targets. Giving an option does not mean the individual becomes a shareholder in the company, this only occurs when they exercise the option. Again, it is up to the company when this occurs.

There are limited restrictions on the exercise provisions that apply to share options. This flexibility means that share options can be used for exit-only arrangements as well as for options exercisable at the end of a performance or vesting period. The most common scenario is an ‘exit only’ option, meaning at the point of an exit (which tends to be a share or asset sale) the individual exercises the option immediately before the exit to allow the option holder to sell their shares as part of the exit. From the company’s point of view, this means the option holders are never shareholders in the company, and from the option holder’s point of view, it means they do not have to pay for their shares at the point of granting as the payment is just deducted from the remuneration they receive as part of the sale. Alternatively, companies may find it useful to link the ability to exercise to performance targets. For example, the share option may become exercisable when turnover reaches a certain level, when a new product is shipped or when a certain stage in the development of a product is reached. Share options can be linked to an individual’s own performance and can be personal to them relating to their own actual targets.

Implementing a share option scheme

Before implementing a share option scheme, careful thought needs to be given to the amount of shares which are available under the option scheme. Future investors may be deterred if the share option is over a large percentage of the share capital. A share option agreement which is over a set number of shares, as opposed to a percentage, is more attractive to other shareholders as five shares and 5% could be vastly different at the time the option is exercised. Equity in every company is precious, so you should consider an appropriate level of options before discussing with your employees.

Share options can be granted to anyone that the directors see fit, for example, consultants, directors or employees. However, for an option to qualify as an EMI, there are several eligibility criteria that must be satisfied, including:

• the option holder must be an employee of the company who works for the company for at least 25 hours per week or, if less, 75% of their working time (known as the ‘working time requirement’)
• the option holder cannot (either alone or together with their associates) control more than 30% of the company
• the company must employ fewer than 250 full-time employees, have a permanent UK establishment, and have relevant gross assets of £30m or less
• the company must be independent (i.e. it cannot be a 51% subsidiary of another company or under the control of another company).

EMIs are primarily used for tax efficiency and it is important you get tax advice on them to ensure the EMI scheme is adopted and maintained correctly.

Alternatives to share options

Share options are not the only mechanism to incentivise staff and other options are available. Growth shares tend to be most appropriate for non-employees but they can also be used for employees. In contrast to the share option, growth shares allow individuals to become shareholders immediately. This type of share can be incredibly flexible – it does not have to meet any statutory requirements and ‘conditionality’ can be applied to protect the business. The logic behind growth shares is the same as options, to attract and retain the best people even if these individuals are not employees. It allows the company to reward their contribution with equity rather than, or as well as, cash.

The rights attached to growth shares are limited so that on a sale the holder will only receive a share in the value of the company above a certain threshold. The shareholder only gets the benefit of the shares if the company grows, hence the term growth shares. This means they will only share in any sale proceeds that are over and above the threshold.

Growth shares are not often appropriate unless a company has real value already, so it may not be a suitable option for a startup. However, they can be a great alternative to EMI options for businesses that are not likely to sell in the short term and a great incentive for individuals to assist in growing the business, while allowing the value that has already been generated to be given to those who created that value.

Get in touch

If you are considering share options or other alternatives, please do get in touch with one of our team – we would be happy to assist in implementing a suitable share option plan for your company.