Share options are one of the many ways startups incentivise, 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.
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 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.
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.
For a more detailed list of advantages, take a look at seven reasons to provide equity for early-stage employees.
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.
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.
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.
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)
This share scheme is 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.
For further information, check out Capdesk’s in-depth EMI guide. If you’d like to know more about other schemes, take a look at the alternative options to EMI as told to Capdesk by Ian Shaw.
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 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.
That brings our quick guide to share options and employee share schemes to a close. If you would like to learn more about employee equity, you’ll find guides, webinars and articles in the Capdesk resource centre.