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What you need to know when exercising share options

Many startups (even the well-meaning ones) do a poor job of explaining share options and equity to their employees. All too often, organisations are not equipped to educate staff about vesting, exercising options or the details of a scheme. And since an equity payout always seems like a far-off prospect, as an employee it's easier not to ask questions.

If you've ever turned to Google to make sense of employee equity, you'll know that there’s a lot of noise and not enough clarity surrounding share options on the internet too.

Once you unpack the essentials, however, share options aren't nearly as confusing as they first appear. With that in mind, we've compiled a simple guide to share options, covering everything from vesting schedules and bad leavers to taxation and liquidity.

Exercising share options

Share options grant you the right to purchase shares at a later date for a predetermined price. Exercising these options converts them into actual shares. The exercise takes place when an optionholder purchases the shares at the fixed price set out in the option agreement – better known as the strike price – regardless of the share price at the time of exercise. 

This can only happen once the shares have vested, the duration of which is determined by the vesting schedule. Many startups choose a four-year vesting schedule that includes a one-year cliff. Once the year has passed, the options that have accumulated over those 12 months vest in one lump sum. The rest of the options vest over the remaining three years.

You could exercise your options as they vest, but there's no real benefit in doing so unless there's a liquidity event on the horizon and a chance to cash out.

When share options are fully vested

When shares are fully vested, it means that the conditions in the option agreement have been fulfilled. If options are awarded on a four-year vesting schedule, this happens after four years.

At this point, you can either exercise your options or hold on to them until a future liquidity event such as a secondary transaction, IPO, merger or acquisition. Consider the tax implications, the current share price and the likelihood of the liquidity event to make an informed decision.

Leaving share options behind

If you're leaving an organisation, think about whether this impacts your options. Are you a 'good leaver' or a 'bad leaver'? There is a rough consensus over what these terms mean, but their exact definition falls down to the company you work for and what's in your share option agreement.

Typically, something that damages the business triggers the classification of a bad leaver. This could be:

  • A breach of employment contract
  • Dismissal due to misconduct
  • Fraud conviction
  • Failure to reach targets before voluntarily leaving

A bad leaver no longer has access to any vested shares and any remaining share options will stop vesting. 

If you don't meet any of the conditions of a bad leaver, by default you're a good leaver. A good leaver has the right to exercise their vested options for a set period of time after leaving the company. This is commonly a 90-day window that starts when you depart but will vary from company to company.

If your shares have fully vested when you leave, make sure to have the funds at the ready to purchase your options within the exercise window.

Paying to exercise your share options

To exercise options, you pay the strike price – the predetermined price set out in the option agreement. The company you work for will get a valuation from HMRC to set the strike price based on the fair market value (FMV) – the price that an asset would sell for on the open market.

If you hold 1000 fully vested options each with a strike price of £5, you would pay £5000 to exercise them all. If your options are under an approved scheme, there will be tax advantages when you exercise or sell your shares. 

The usual process of exercising options requires you to cover the cost of purchasing those shares. However, if there's a same-day sale, you might be able to run a cashless exercise. This is where an employee exercises options without having to cover the cost of the exercise price.

The transaction uses a short-term loan provided by a brokerage firm which covers the cost of the exercise price, tax, and a commission. The final balance is paid to the employee.

Share options and tax considerations

When you purchase share options, you pay Income Tax and National Insurance Contributions (NICs) on the difference between the strike price and the company's share price. You will also have to pay Capital Gains Tax (CGT) when you sell your shares. This is set at 10% or 20% depending on your tax band. In the UK, you pay this when you exercise your options, not when they're granted. 

However, if your options are awarded through an approved share scheme, the tax implications are different.

Enterprise Management Incentive (EMI) – you do not pay Income Tax or NICs when you exercise options granted through EMI, providing the strike price was not lower than the market value of the shares when the option agreement was signed. CGT still applies to the profit you make when you sell the shares.

Save As You Earn (SAYE) – you do not pay Income Tax or NICs when you exercise your options. CGT is payable when you sell but you can work around this by transferring the shares to an ISA or pension.

Company Share Option Plans (CSOPs) – you do not pay Income Tax or NICs as long as the options aren't exercised until at least three years after the grant date. CGT still applies when the shares are sold.

Liquidity and your financial situation

The decision to exercise your options can boil down to your financial situation, how you’ve been awarded the options and what your expectations are for the future of the company. 

Under tax-advantaged schemes such as EMI, CSOP and SAYE, or with access to a cashless exercise, exercising options may be within reach. 

If your options are unapproved, it’s a smart move to exercise fully vested shares when the difference between the strike price and the share price is still low. However, you’re gambling on the share price continuing to rise in the future and betting on the chance of a future liquidity event to realise their value. You’ll also have to pay to exercise the options out of your own pocket.

 

Are you thinking of leaving the company? Can you afford to exercise your options? Does it make financial sense to exercise your options now and tie up some of your wealth in an illiquid asset? There are many questions to answer when thinking about exercising employee options.

If you’re unsure about what to do with your options, speak to an expert. This could be the person responsible for managing employee options at your company or an independent financial advisor. To find out more about how share options are exercised, or about equity in general, explore the Capdesk resource library.

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