Share options are one of the many ways startups incentivize, motivate and reward employees. They are a powerful tool that can unite a team towards a long-term goal and allow you to hang on to top talent for longer. So how can you ensure that employees understand the full potential of their share options?To help you provide your employees with a comprehensive understanding of what share options are – and how they work – here are the five things all employees should know. In this mini-guide, we cover employee share option schemes, vesting schedules and share option agreements.
What are share options?
A share option is a contract issued to an employee (or another stakeholder) giving them the right to purchase shares in a company at a later date for a predetermined strike price. Share options grant you the ability to buy those shares and become a shareholder in the future. Once converted from options into shares, the individual then owns part of the company.
Why do startups award share options?
One of the most common reasons why startups grant share options is that they’re strapped for cash and often unable to pay the market rate to attract top talent. Nonetheless, they still need those quality hires to reach business goals making the promise of long-term financial gain a worthwhile alternative form of compensation. Employees who take the risk along with a reduced monthly income have the potential to benefit from a significant financial reward, should the company succeed. It’s a great way to motivate your workforce, retain world-class talent and align multiple stakeholders towards the same goal – the startup’s success.
Five things employees should know about share options
1. The value of share options
One of the first things you’ll probably want to know when you’ve been granted share options is how much they will be worth when the payout comes. Unfortunately, it’s not that simple as this is dependent on the company’s valuation – which is set to change as the business grows. Other factors, such as the dilution of company ownership brought in by new rounds of investment, also have an impact.
However, it is possible to calculate the value of your options if you exercised them on the day of the grant. You will find the predetermined strike price in the share option agreement along with the share price from the most recent valuation. The difference between these two numbers – after multiplying each price by the number of options you’ve been granted – is what your shares are worth. Don’t forget about the tax implications (see below).
It’s important to remember that your options aren’t technically worth anything until after they’ve fully vested and been exercised. As a shareholder, the payout only comes at the point of liquidity: an IPO, M&A or a secondary transaction. Holding share options simply gives you the right to purchase shares in the future.
2. Vesting schedules
Vesting schedules determine the time frame over which you accumulate your options. Many startups opt for a four-year vesting schedule with a one-year cliff. In simple terms, this means that you gradually earn your options over four years but this doesn’t officially startup until one year from the start date – also known as passing the cliff.
After this one-year marker, 25% of your options vest as one block, as you’re now one-quarter of the way through the four-year schedule. Typically, options vest regularly at monthly intervals for the remainder of the schedule. After two years, 50% will have vested and after three years, 75%, and so on.
An exception to the rule takes the form of a back-weighted vesting schedule which recognises that the value an employee delivers continues to increase over time. In year one, at the cliff, only 10% vests, increasing at 10% increments up to 40% in the fourth, and final, year.
3. Tax implications
Tax considerations play a major role in determining how much you’ll receive when you exercise and sell your shares.
In the UK, options aren’t taxed when they’re granted or fully vested. Instead, taxation happens at the point of exercise. You’ll have to pay income tax and national insurance contributions (NICs) on the difference between the strike price and the share price. It’s also worth noting that Capital Gains Tax (CGT) is due when the shares are sold in a liquidity event.
In most instances, as an optionholder, you’ll have to front the cash to buy shares – unless there’s an arrangement with a brokerage for a short-term loan as part of a cashless exercise.
As you can see, you can end up paying a significant amount in tax to access the value of your options. However, employee option schemes can help mitigate some of this additional cost.
4. What are employee option schemes?
Startups that want to award options to their workforce set up employee option schemes. Though there are several different types, they all typically make exercising options more tax-efficient for employees. In the UK, there are several schemes available:
Enterprise Management Incentives (EMI)
EMI share schemes are the most popular in the UK. It provides a tax-efficient means of rewarding, incentivising and retaining qualifying employees. Amongst other benefits, options granted through the EMI scheme won’t be taxed at exercise (income tax and NICs). You will pay 10% in Capital Gains Tax (CGT) upon sale.
Company Share Option Plan (CSOP)
CSOPs are another government-approved employee option scheme. Employees do not pay income tax or NICs on the difference between the strike price and share price when they exercise their options. You can only exercise the options three years after the grant date and CGT applies at the point of sale.
Share Incentive Plans (SIP)
A SIP requires shares to be held in a trust for a minimum of five years in order to see any tax benefits. You will not pay income tax or NICs on their value. CGT is not due at the time of sale, if you keep the shares in the plan until that point in time.
Joint Share Ownership Plan (JSOP)
This is an unapproved scheme that is not subject to tax advantages. An employee, together with a third party employee benefit trust, jointly acquires shares in the company. At the time of receiving the shares, income tax is due. Upon selling the shares, they are subject to CGT.
5. What is a share option agreement?
The share option agreement is a legal contract that gives an individual the right to purchase shares in the future. It also details the conditions that the individual must meet in order to buy those shares and all the associated terms with the purchase itself. Complex terminology fills the pages of share option contracts. Here are the most important terms explained:
Option agreement terms
Number of options granted – the total number of shares you will be able to buy once the other terms of the agreement have been met
Strike price – the pre-established rate you will pay to buy the shares granted through your option agreement. Also known as the exercise price
Vesting schedule – the preset schedule which determines when employees can acquire full ownership of their granted assets. This takes place gradually – commonly over four years
Bad leaver – if an employee is dismissed from the business due to gross misconduct, they are a ‘bad leaver’ and will no longer have access to any of their vested options
Good leaver – a ‘good leaver’ has the right to purchase any vested options for a set period of time after leaving the company. This window typically lasts 90 days but will vary from company to company.
Option agreements do not have a set format which means they can look different in each business. Therefore, if you’re unsure about what you’re signing, seek the advice of a legal specialist. They will provide professional guidance.
Share options vs shares: What difference does it make for early-stage companies?
There are two ways to reward employees with equity: shares or share options. The former choice is awarded to employee shareholders who can enjoy the benefits immediately. While options are granted to employees as a potential financial bonus in the future. Both act as a reward and incentive for employees, so why would a startup favor share options vs shares? What’s the difference between share options and shares? And why are options an attractive proposition for employees? Let’s find out.
Share options vs shares: what’s the difference?
1. Company ownership
A share option grants you the right to purchase shares at a later date for a predetermined price – also known as the strike price. Options are typically awarded gradually over an agreed period, known as the vesting schedule.
Vesting schedules and how share options work vary from business to business.
Shares, by contrast, represent a piece of a company. Shareholders in early-stage companies might include external investors in the primary market, including angel investors, family, friends and founders. Later a startup might seek investment from a VC fund in exchange for a number of shares. Shareholders are entitled to a portion of the profits, which are paid out in the form of dividends. They also enjoy other benefits, such as voting rights.
2. Forward vesting and reverse vesting
For early-stage companies, it’s relatively straightforward to issue options to employees. Options can be used as a tool to compensate for the reduced salary early-stage employees take to embark on an exciting startup growth journey. Whilst powerful, options don’t come with any voting rights for employees.
To extend the incentive of options, they are awarded according to a vesting schedule. A typical schedule for share options lasts four years including a one-year ‘cliff’. The optionholder receives nothing for the first year, after which 25% of the options are granted immediately. The remaining 75% vest incrementally over the remaining three years of the vesting schedule.
If the employee leaves after one year, with only 25% of the options vested, they can exercise the options and convert them into shares. However, this is dependent on whether the employee is a good or bad leaver. These terms are laid out in the option agreement and are key to understanding startup equity.
If you already own shares in a company, reverse vesting acts as protection for the company: a leaver can’t depart with a significant stake in the business. In short, if you leave, before the vesting schedule is complete, you’ll have to sell a portion of your shares – usually at no profit – back to the company.
In the case of reverse vesting, if a schedule was set to four years and an employee leaves after one year, the company is entitled to repurchase 75% of the shares.
3. Equity compensation and cash payment
Once shares have been issued at a nominal value, the shareholder owns them. A company will try to keep this value low so that the shareholder doesn’t have to dole out a large lump sum next to receive them and won’t pay anything further in the future. Right away, the shareholder is entitled to a portion of the dividends, should the company make a profit.
However, there may be conditions attached to the shareholder agreement that make sales and purchases more complicated It’s always a good idea to go through the contract carefully or ask for professional advice if you don’t feel you have the necessary expertise.
On the other hand, options require no payment upfront. Once vested, however, the optionholder will need to pay the strike price to exercise their options and convert them into shares. At this point, the optionholders must pay to exercise the options. If there’s no liquidity event on the horizon, such as a secondary transaction or IPO, this is a risky move.
4. Taxation of share options vs shares
When you’re allocated shares, you receive a slice of the business and start benefitting from that point on. As a result, there’s an immediate tax charge for both the employee and the employer.
The nominal value of the shares is agreed upon with HMRC using the price paid per share by investors in the last funding round. When purchased, shares are subject to income tax and National Insurance Contributions (NICs). These taxes are due on the difference between the nominal value and the market value of each share.
However, with options, taxation is delayed until the point of exercise, when options become shares. Income tax and NICs are payable on the difference between the strike price and the actual market value as agreed with HMRC at the time of the grant. Capital Gains Tax (CGT) is due if and when the shares are sold on.
Tax-advantaged EMI schemes reduce the burden of tax on employees when exercising vested options. When an employee purchases their options through an approved EMI scheme, they do not have to pay income tax or NICs and CGT is capped at 10%.
Why are share options more popular among startups?
There are many reasons to provide equity for employees in early-stage startups. In scaling businesses, share options are one of a startup’s greatest weapons – a unique tool to attract, retain and incentivize talent. They allow smaller companies to compete for the best and the brightest in the labour market, at a time when they can’t always match market-rate salaries.
In fact, there’s a noticeable link between offering share options and employee satisfaction and productivity. Compensation – be it be base salary, bonus structures or option schemes – raises the bar for employee motivation.
Employee equity fosters a sense of community and a deeper connection with a company. Enrolling employees on an option scheme also encourages loyalty and makes individuals feel both valued and fairly compensated.