Over recent years it has become more common place and, particularly in tech sectors, almost expected, to grant employees options over shares in the company. The purpose of this is to incentivise employees, most often by giving them an opportunity to take part in an exit should one come about. This article seeks to set out in basic terms what an option is and shed some light on some of the intricacies you might want to think about for your company and employees.
An option is a right that entitles the option holder to acquire shares at a certain price at a certain point in time usually subject to a condition such as an exit happening or perhaps a sales hurdle being achieved. In order to exercise options the holder of the option will have to pay an exercise price. Companies can include mechanisms that allow for cashless exercise to avoid the employee having to find the purchase money.
How it works
An option plan is discretionary. This means that you can choose which employees receive options and how much each of them gets. If you wanted, you could grant an option to only one person.
A company can adopt a set of plan rules, which allows the company to grant options to several employees at the same time and new options to more employees in future, all on the same terms. This is generally the better approach for a large or growing pool of employees. However, standalone tailored options for a small number of early employees/founders might be better suited to your requirements and is something we can advise you on.
Once an option holder has exercised their option, they are in the same position as any other shareholder. So if the exit is a share sale, the option holder will sell their shares to the acquirer as part of the transaction.
What is EMI?
EMI is the most tax-efficient share plan available. Your company accountant will be able to provide advice on the tax benefits of such a plan for the company and its employees. As noted below, the company will require input from its accountants to obtain a valuation and approval from HMRC as best practice to ensure the option price is secured.
To be eligible to be granted an EMI option, an employee must work for the company for at least 25 hours per week, or if less, 75% of their working time.
Why exit only?
An exit only plan means that employees will not become shareholders until there is an exit opportunity for all the shareholders. This could be a trade sale, an asset sale, or an initial public offering or floatation.
An exit only plan is ideal general employees so that they do not become minority shareholders without being able to sell their shares. Using an exit only plan avoids this possibility and the problem of having the employee arranging cash to purchase the shares. If the option can only be exercised at Exit then the company can simply deduct the option price from sale proceeds.
Vesting and Performance requirements
You may decide to award option shares that accrue to the employee over a period of time. For example, you may grant an option over 500 shares to an employee but only 100 vest each year. This encourages the employee to remain with the company for 5 years. You might include a clause which allows for an acceleration of vesting if the Company is to exit earlier than the vesting period.
What should happen if an employee leaves the Company? Normally, the option will lapse but the board will have discretion to allow the employee to keep any options (sometimes restricted to those vested in line with the vesting schedule). If it is an exit-only option then the option would remain exit-only so not capable of exercise until an exit.
HMRC Advance Clearance
The company will need to instruct its accountants to apply to HMRC for “advance assurance” that the company qualifies to grant EMI options. The assurance lasts for 90 days during which the company can grant options based on the assurance valuation.
The EMI option plan must be registered with HMRC and you company’s accountant can assist you with that. In order for an EMI option to qualify for favourable tax treatment, the grant of the option must be notified to HMRC within 92 days of the grant date.
Get in touch with the MBM Commercial Options Team at OptionsTeam@mbmcommercial.co.uk to find out more.