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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 favour 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%. 

If you’re considering this in the near future, brush up on what you need to know when exercising your share options.

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 incentivise 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. 

 


To find out more about the role of share options in startups, take a look at the Capdesk guide. For more general information, advice and guidance on share options, head to the Capdesk resource centre.

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