Employee share options explained: A guide for option holders

Hello, I’m Anthony founder at SeedLegals. And I’m here to tell you as an employee some things to help you understand what share options are. Are they valuable? When can you get value from them? Why you even getting them? What does it all mean?

Now there many many articles on the internet about share options, but they’re all written for companies how to issue them to your employees, but for employees, there’s almost no information I could find so I figured I’d make this video.

So the first thing: what are share options?
Well, the first thing is we all know what shares are. You’ve got shares in Apple or Revolut or whatever, and shares gives you a fraction ownership in the company. So why doesn’t the company just give you shares? The reason is twofold. Firstly tax issues. If you give someone free shares, particularly if they’re an employee, they’ll have to pay Income Tax on it. And since you’re not selling your shares for a while, giving you shares will be an expensive negative thing. Here’s some shares for you – by the way, you have to pay HMRC a lot of money. So giving an employee shares is probably a bad idea. The second thing is once you give an employee shares you’ve got filings to do on Companies House for the company and there’s a whole lot of paperwork. So for these reasons companies tend not to give their employees shares and instead they give them share options.

What is the share option? A share option is the right to buy a share later and to make it valuable for you. It gives you the ability to buy it later for a very low amount of money, even though the share’s worth a lot more later, which means you pocket the difference later and if you’re a UK employee and the company qualifies, there’s a very generous HMRC scheme called an Enterprise Management Incentive – EMI options. You’ll keep hearing that – it makes options a very attractive way of rewarding employees and if you receive EMI options, it means when you sell the shares later, you’ll pay only 10% Capital Gains Tax on the difference between with the amount you paid for the option and the value of the share later. A much better tax rate than any other system. It’s a great way of rewarding team members.

The next question is OK, great, the company’s going to give me share options options which will cost me less tax than shares and
importantly with options, you only pay the tax when you sell it later and you make money as opposed to giving the company giving you shares today and you have to pay tax today potentially on value you may not get for years. You might be thinking are share options worth less than shares, are they less good than shares? Well, if you get shares in a company, those shares if they have voting rights, mean that you can be a voting shareholder and you get management reports and things from the company. As an option holder, you don’t have voting rights – at least not until you exercise your options – and so you don’t have a say in the company. Now, realistically, an employee is going to have a very small amount of options. It wouldn’t matter if they had a vote or not. Companies will often give employees share options instead of shares because they don’t want them coming to shareholder meetings and so on because it’s a nuisance that interferes: ‘these are investors and shareholders, and these are our team’.

The next question is how many options should you get? Let’s say you’re a developer at a company and they go, ‘hey, we’d love to give you some options – we’re going to give you a thousand options’. Well, is that a huge amount or is it a nothing amount? Giving a number of options like a thousand isn’t very useful because you don’t know if the company’s got a million or a billion or 20 shares so a company might give you a percentage of their equity in options. You getting 0.1% now – that doesn’t sound very impressive but let’s look at the maths.

When a company does a funding round, they’ll often allocate some equity some percent of the total shares for employee options and retention and so on and the typical standard is 10%. So 10% of all the equity is reserved for an employee share options scheme. Let’s say the company’s planning to have 100 employees before it exits. So that’s going to be you know, 10% divide by 100 – roughly 0.1% per person. Now that doesn’t sound potentially hugely exciting. But if you think the company is going to sell for $100 million, then 0.1% means your share options are worth $100,000 and you’re going to pay only 10% Capital Gains Tax on that. So getting share
options, even if there is small amount, it can actually be really valuable if the company has a significant exit price later.

And by the way, my suggestion is rather than talking about a number of options or percent, it’s good to talk about the value of it. ‘Hey, we’re going to give you £20,000 worth of options at today’s valuation. And then if the valuation goes up 10x, they might be worth £200,000 if you’re still with the company then or if you exercise them.

The company giving you options – they figured out how many options they’re going to give you but the next thing is vesting. If you’re employed by a company, they don’t pay you an entire annual wages on 1 January. You get paid bit by bit each month and likewise with share options. You’d never go, ‘I’m giving you £20,000 of share options, and by the way, if you leave tomorrow, they’re all yours’. Instead it’s called vesting. You could say, ‘I’m going to give you every month, just like I’m paying you, I’m going to give you a few more options’. But the paperwork is an admin nightmare. You don’t do that and instead you say, ‘I’m going to give you 20,000 options’ (let’s say) ‘and they’re going to vest over a number of years. This means that every month you’re going to
accrue more of them. And if you leave after a year, you’ll keep (let’s say) a third and the rest go back to the company. Vesting is a way of progressively giving you entitlement to more of the total amount that you’ve been promised.

The next question is how long should they vest over? If they vest over ten years, it means you have to be with the company for ten years to get all of them. What is the pattern? The most usual vesting schedule is the options will vest over four years from when they granted, with what’s called a one year cliff. If you look at your Option Agreement and you see there’s a cliff, that means in the
cliff period if you leave in that time, you get nothing. Not all things work out, right? The company might hire somebody and in the same way there’s a probation period, you can terminate on both sides with short notice – when you give someone options, if the idea is they’re a reward for sticking around, then you have to stick around for at least the minimum period before you’ll get any. If you’re getting share options and your Option Agreement says it’s four year vesting and a one year cliff, this means that if you’re with the company for four years, you have all of your options. If you’re there for two years, you’ll have half of the options. If you’re there for one year, you’ll have 25%. And if you stay less than one year, you have zero.

Now you’ve got these options and the vesting gives you an increasing entitlement to them. The next question is: can I sell them? I’ve
got (say) 20,000 options with 1,000 vested. I want to sell them now and get money from my shares. The process of doing that is called exercising your options. So an option might say hey Alice you can buy a 20,000 shares in the company for 10 pence each.
And if the price of the shares later is 10 pounds each you can pocket the difference, but when you exercise the option and pay the company the 10 pence per share you now going to get your shares, but the company’s got a bunch of paperwork to do with companies house and issuing more shares and you’ve come a shareholder and it’s a bit of a nuisance. If the company has 100 employees and they’re busy writing to the CEO once a week: ‘I’d like to exercise another 10 options, please’, it’ll drive them crazy, so many companies set what’s called an exercise window. Just because you’ve got a few more options that you have an entitlement to, it doesn’t mean you can exercise them and turn them into shares when you want – only at certain times. Sometimes the company might choose every January: for a week you can exercise and if you didn’t do it, then wait till next year. Well, sometimes you can only do it once you leave the company then you can exercise, and sometimes it’s only when on the sale of the company, then you can exercise and if you leave before then you lose everything. That’s called an exit only scheme. An exit only scheme is designed to reward employees who stay with the company for the entirety of the journey of the company. If the goal of the company is to grow, have a great exit, and reward everyone who stays the duration, that is in exit only, and the median time for startup to exit is five to seven years. If you plan on being around maybe only to year three and it’s four years statistically, then you might plan around that as well.

One of the things to know is you only get these fantastic EMI tax benefits if you’re an employee of the company. This means that if you stop being an employee, you have to exercise your options within 90 days of leaving the company. You can’t go, ‘I’m going to keep hanging on to my options’. No, once you leave you have to exercise them. If the exercise rules allow you to still keep them at that time, and enough of them vested, this becomes a problem potentially because when you exercise your options, you have to pay what’s called the exercise price and the exercise price is agreed with HMRC in a way that gives you the maximum benefit and the lowest taxes. It does mean you have to pay something for it and it may turn out that if you have options, you may have to pay a few hundred pounds or even a few thousand pounds to exercise your options when you leave the company and this means quite a few employees potentially just don’t have the funds or don’t think it’s worth it because they’re not convinced. The company will have value later and that’s why the company works super hard to get the lowest possible what’s called EMI valuation so you paid the least amount. You can ask the company what the EMI valuation might be and you should probably see that on your option grant.

Talking about option grants: you’re going, ‘OK great, I’m getting these options. I hope they’re going to have a lot of value later. What paperwork do I need to do? The company is going to create a share option scheme and they’re going to give you an option grant to sign saying, ‘Dear Alice, you now have so many options which will vest over so many years with these exercise provisions’. And the paperwork is a bit complicated. It’s a bit of an eyeful. If the option scheme is done on SeedLegals, we create a very nice cover letter that shows in a few sentences: ‘Dear Alice, you’re going to get so many options and they vest over this many years’, to try and make it clear.

So thing number one, you’re going to sign your option grants and you now got options great. Now at some point later you’re going to go. I want some value for my options. I’m going to exercise them. And if you pick the the time when you can exercise them in the exercise window, then you go into right to the company and you’re going to fill in what’s called an exercise notice and that should be on your seed legals portal if the company’s use illegals, or you can ask them to send you the exercise notice and it’s gonna say, Dear company. I wish to exercise my options this number of options and I’m going to enclose a wire transfer or a check if anyone still uses checks for the exercise price. Please send me my shares. At this point the company might ask you to sign what’s called an NIC election and an S431 election and these are tax things to say that any tax liabilities that may arise sit with you not with the company. These are pretty standard be prepared to sign them. You can do some Googling at the time probably it’s going to be a while you get there to find out exactly what they mean and you’ll probably find articles on seed legals quite a few of them on what those mean the be prepared to sign those two documents.

So at this point you’re thinking ,Great. I hopefully know a bit more about options but reality check how much will my options be worth? So let’s run the numbers and broadly, you know, most UK companies, we all eye those unicorn exits. Someone sells for billions and employees made millions. To reality check – from what I’ve seen typically employees might expect their share options to be worth £20,000, maybe to £100,000 if they’re an early employee on an exit of the company and maybe it goes something like this. The median exit on a UK company might be on the order of £20 million. It might be a hundred million or more but most are in the sub 20 million range. And if you’ve got 0.1% equity, roughly, I mean it might be a lot more. It might be a lot less on a £20 million exit that’s £20,000 on a £100 million exit. That’s £100 million. So £100,000, 10% capital gains tax. That’s a nice way to you know, get the mortgage paid off the mortgage or whatever. So those are quite life-changing amounts. Of course, the company might have a much smaller exit. It might be £5,000. It might be zero if the company doesn’t do well, but that’s the bet that you’re placing that the company having a successful exit and you having options will make it a win-win for all/

So to wrap up, your company’s going to give you options. You’re gonna sign the Option Grant, you can look at the vesting and exercise periods later on, either when you leave the company typically or a sale of the company. You would exercise the options sell the shares and and then of course make something now. The one of the questions is when can you sell your shares? You’ve exercised the options? You’ve got the shares. Can I sell them and the answer is generally for a private company, unlike on the stock market where there’s liquidity and you can sell every day, in a private company generally the times that you can sell your shares are on a sale of the company itself. Someone buys the company, everyone sells their shares. Hopefully. Or it might be when the company’s doing its next funding round. And then your investors are looking to buy out the earlier shareholders. So both of those are called liquidity events, and those would be the opportunities where you would be able to sell your options and make some money.

Now one of the other things quickfire things you might come across is that when you want to exercise your options, you have to pay money and then later on you sell the shares and you make more, sometimes companies are able to combine them to one event called a cashless exercise. So instead of you having to wire money to the company to own the shares and then minutes later or days later, sell the shares and get the difference. They might work it all out for you and just pay you the difference – that’s called a cashless exercise and only works if the time you want to exercise the option and the time you sell the share are about the same time.

So that is it. I hope that helps and by the way, if the company does their options scheme on SeedLegals, you can log into SeedLegals and you’ll see your personal option dashboard and it will show you your vesting schedule and you can type in evaluation of the company and the platform works out how much your options will be worth taking into account the exercise price. So you could log in every day. I wouldn’t encourage that because things don’t change that quickly, but you can log in frequently type in valuations, don’t hassle the founders too much what it might be, but you might have a best guess you might just pick things and then see how much your options are worth one day. They are worth something – fantastic. So if you’ve got any questions, head over to SeedLegals, hit the web chat to ask us or ask the founders in your company.

Enjoy the options. Thank you.