Co-authored by Chris Parsons, Trainee, Corporate Team
Our Corporate Transactions team are seeing an increasing number of transactions that involve the exercise of employee share options prior to the sale of a company, particularly in the tech sector. HMRC reported that a total of 13,330 companies operated tax-advantaged employee share schemes in 2017/18 (an increase of 12% on 2016/17), and estimated that in 2016/17 the grant of shares and options pursuant to employee share option schemes amounted to £3.11 billion. Is this a solution to employee motivation and retention that could work for your company?
Technology start-ups are often reliant on a few key individuals to boost the company’s early growth and who are vital to keeping the business at the forefront of tech innovation going into the future. However, start-ups by their very nature are unlikely to be able to compete with bigger tech companies on salary and other employee benefits, and so motivating and retaining these key members of your team can be challenging.
This is where share option schemes may have a role to play.
Simply put, by issuing, say, 100 share options to an individual, a company is effectively giving that individual the option of buying those 100 shares at a later time (usually on a sale of the company or other event, such as the company meeting growth or revenue targets) but for a price agreed at the time of issue. Option-holders are therefore able to benefit directly from the growth of the company (and increase in value of the company’s share capital) and are rewarded for their commitment to a start-up that may not otherwise be able to offer a competitive compensation package.
A key to the continuing success of share option schemes is significant commercial flexibility as to (a) the mechanism by which the options are ‘exercised’ (i.e. future purchase of the option shares by the option-holder), and (b) the potential conditions which must be met in order for share options to be ‘vested’ in the option-holder. For instance, a share option agreement may specify that options can be exercised only on a sale of the company for more than £x million, or that options will be issued to an employee at a rate of 100 option shares per year of service or according to specific growth targets. As a consequence, share options schemes are seen as a pragmatic tool to incentivise performance, to improve retention and to give key individuals a vested interest in the future growth and performance of the company, and all on the company’s own terms.
So, could a share option scheme work for your company?
What is the company’s ultimate goal?
Tech start-ups often grow incredibly quickly before being sold by their founder shareholders to a bigger player in the tech market. If a company’s strategic direction is rapid growth and exit, then issuing share options to key employees may help to get them on board for the duration. However, if the company is growing at a steadier pace or there are no plans to accelerate towards a sale of the company in the near future, then the grant of share options whose exercise is linked to an exit event such as a sale will provide little incentive to stay with the company.
It’s all about equity!
In short, how much of the company are you willing to part with? Typically, UK companies choose to offer up around 10% of the issued shares in a company as part of a share option scheme. It’s important to strike the right balance between an award of share options which is substantial enough to incentivise and retain the option-holders as employees of the company but such that the shareholding of the founder shareholders is not overly diluted.
Grant of shares vs share options?
Another common practice is for start-ups to ‘give’ shares to employees in return for their services. At first glance, this may seem a less complicated (and therefore more attractive) way to incentivise key employees. For instance, share options are by nature, something of an intangible asset until they are exercised. However, the grant of share options can be structured so as to ‘vest’ over a period of time (e.g. x number of share options per year worked for the next y number of years) thereby playing a greater role in employee retention in the medium term (rather than the immediate grant of shares which provides little direct incentive for an employee to stay in the longer term). Share option schemes also sidestep the added complication of giving shareholder rights to employees or, alternatively, having to implement a new shareholders’ agreement to counter those rights.
Did someone say ‘tax relief’?
Employee share option schemes fit broadly into two categories: approved (by HMRC) and unapproved. One such example of an approved scheme is an Enterprise Management Incentive (EMI) scheme. Aimed at smaller companies with high growth potential (the company must, amongst other things, have gross assets not exceeding £30 million and less than 250 employees), employee option-holders under EMI schemes are only charged Capital Gains Tax on the increase in the value of their shares from grant to exercise (provided that the options were granted at not less than market value), rather than being charged Income Tax and National Insurance Contributions on that gain. Of course, approval from HMRC should be sought in relation to the market value of the shares prior to the grant of the options to ensure that the option-holders are able to benefit under the scheme. Given that tech start-ups will often fall into this ‘small company’ mould, they are generally well-placed to benefit from this government initiative.
If you’re running a fast-growing start-up in a dynamic sector such as technology, and your workforce is key to the future success of the company, then share option schemes are certainly worth thinking about. Our Corporate team have extensive experience in advising on, and implementing, share option schemes and would be happy to discuss this further with you. Chris Dobson ([email protected])
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