My name is Hugo. I am an equity strategist here at SeedLegals. What that means is I work primarily with founders on issuing equity to anyone, whether that’s an investor or an employee.
So we have the funding side of the business. I sell the other side, and primarily that means share options.
- How do we reward employees?
- How do we incentivise employees?
- How do we give away or how do we avoid paying cash bonuses and use equity instead?
Stuff like that. That’s where I come in. My background is law. I was a lawyer before I came over and that’s basically what I do. So this webinar is on share options and how they can be used, as it said right there, how they can be used to motivate your team before Christmas.
The reason we’re doing this in October is because Christmas is coming and it’s becoming more and more prevalent. With that, I’ll get to it towards the end, the EMI valuation that you need to do before actually issuing employee options. That’s why we’re doing this in October. And that’s crazy to talk about Christmas in October, but there we go.
The first title, I guess, the first slide is kind of just describing what share options are. I’m sure there’ll be a fair amount of people on the call that understand this entirely, but I think it’s important just to kind of walk down exactly what they are and how they differ from shares, straight equity.
Share options are the right to future shares. They are a placeholder. They are a placeholder of shares. They don’t actually exist yet. That is they are granted from an option pool and they can be divided into different schemes. That’s the premise really.
You have either the choice of issuing someone shares, which means direct ownership, direct tax implications. That could be subject to reverse vesting schedule, or you can issue them options out of an option pool, which is essentially the right to equity in the future on a vesting schedule depending on what happens. You can rip up that contract and move on. You’re not tied down. You don’t have to go through a messy clawback process or buy back the shares.
When sharing an option, it’s just a contract, but I like to say an option is as good as a share certificate so long as the criteria in that share option agreement is met. That’s the major difference really – to share versus an option, right to buy versus actual ownership.
And why do we give them? So there’s kind of three main pillars here.
- We give them to attract talent.
- We give them to motivate talent.
- We give them to retain talent.
Attracting is probably one of the main reasons I see today when I speak to founders, particularly tech founders who are trying to bring in the big dogs, you know, great top talent from any big companies like big four consulting firms, management consultancy companies, investment banks, finance companies that have the ability to pay higher salaries than your everyday tech startup. And so as a way of luring them in, you may give them a slightly below market salary but you top up that salary in equity, whether it’s kind of 0.5, 1.5% and beyond. We can talk about percentages at the end if anyone has any questions on that. But that is a major player for why you issue share options in the market today.
Motivate and retain are fairly linked, I’d say. Motivate – you know, the idea kind of linking back to the last slide I just mentioned. You’re not giving them straight equity. You’re giving them the opportunity to earn that equity over a period of time. And so the motivation there is you want these, your staff to feel part of the journey. You want them to feel motivated and that they are kind of pushing towards a similar goal as you. You want them to have skin in the game so that they would push the valuation in the same direction you want that valuation to be pushed. It’s in their interest as much as it is yours. And that’s a big part of the motivation aspect.
The retention aspect, similar to the motivating, but it’s more down to maybe the vesting schedule. The idea behind retention is we put them on a vesting schedule. We introduce a cliff period. We say look, you’re gonna have to stay at the company X number of years or you’re gonna have to pass these hurdles over many years. You can do a combination of the two. But really it’s about keeping the best talent at the company, giving them a reason to stay. Obviously there’s gonna be a few others, but a big one is if I stay for two, three, four, five more years, I’m gonna receive X percent equity in this company. That’s a big reason for me to stay because the company’s moving in such an exciting direction. And that’s the third main pillar, I’d say.
Kind of linked to that as well is Christmas bonuses. A lot of employees out there are expecting maybe a Christmas bonus of some sort, whether it’s big or large. You know, does your current cash flow allow for this? You know, can you think of other ways to reward employees that maybe are less expensive? We’re living in crazy times at the moment. You might not have cash. You do have loads of equity.
Obviously it’s extremely important to be careful with equity and that’s why you have a team of experts that help with this kind of stuff. But really, it is a great alternative to Christmas bonuses, a lot cheaper. You’ll basically be deferring that payment until when the company sells, when there’s a cash injection. And you know, at the same time those three main pillars, the motivating, the retention aspect, that’s also kicking in. And you’re getting a double win really as well. So definitely one to think about, Christmas bonuses.
What is EMI? So once you have your option pool established, you’ll have to assign a certain scheme. The two schemes we see at SeedLegals are the EMI scheme and the unapproved scheme. I’ll talk about the EMI scheme first and in detail. I’ll kind of move towards the unapproved at the end. The reason being, this is about motivating employees. Employees sit on an EMI scheme. EMI is Enterprise Management Incentive and it is by far the most tax efficient way to actually give equity out in this country. There’s no better way of doing it. You can issue someone shares today but there’s gonna be liability on that. I think they’d have to pay income tax or pay a substantial amount for that equity based on the most recent valuation. And so the EMI scheme was set up as a way of motivating employees and also making it more appealing, more cost effective for them to eventually receive that equity and for you guys as founders to set that up.
If I go to the next slide, who can offer it? It’s a fairly broad spectrum of companies that can offer EMI. It is very specific exclusions to SEIS and EIS. If you qualify for SEIS and EIS business, you automatically qualify for EMI so it’s the exact same restrictions as it is for SEIS and EIS. Typically the only companies that are prohibited are companies that are dealing in property, land, property development, money lending. I don’t have a comprehensive list. I mean by all means, please let me know, message me after if you think you might be ineligible, but it basically, it’s rare that I speak to a founder whose business doesn’t qualify.
The more restrictive things are how many you can give out. Three million is the limit for the company and 200,000 per employee is the limit on EMI options. 30% max, I think, is actually fairly generous. It means each individual can have a 30% stake in the company, or 29% stake in the company, and still qualify. But EMI, I mentioned this because I actually often speak to founders bringing on co-founders who are going to receive less than 30% at a late stage. So maybe the co-founder or maybe the founder just closed a round. Suddenly there’s a valuation attached to those shares. They could issue that new incoming co-founder, make issue them, you know, 10% whatever it might be, but that 10% will be extremely expensive. They’d have to find the money to buy that 10%. And if not, there might be income tax liability immediately due. And so often a founder, a late-stage co-founder that might come on board, can actually participate in the EMI scheme rather than be issued straight shares in the company. And that’s why I mentioned that 30% level. It’s a much cheaper way for that co-founder to come aboard.
I’ll mention the valuation. I think it’s on the next slide or one after, but the first thing we do is do an EMI valuation. After that’s returned, we issue the share option. When we’re issuing that, that’s basically, that’s coming out of the option pool. So if you had 10,000 shares maybe in your option pool representing 10%, for example, that’s very typical. Say you wanted to issue 2% of the pool, you issue 2000 share options. Nothing is being, no equity is being issued at that time. You’re giving them a contract, that contract will have separate vesting conditions. At the end of which, when the vesting is complete, the options will be potentially exercisable. So the exercise point is the point the option converts to shares. It’s as simple as that. And so at that point, there’s no income tax at all for the employee today.
When are the shares then sold? So the option converts to shares and then maybe a few years later, an exit happens or liquidity event happens, and they sell their shares to a buyer. They’re only subject to 10% capital gains at that stage rather than 20. So they, the only tax they ever pay, that’s ever payable, is 10% capital gains at point of sale, which is similar to the position of a founder. The EMI is basically a scheme that puts the employee in the shoes of a founder from a tax perspective. So it’s incredibly, it’s very interesting for an employee. And that’s why if your company has 250 employees or less, it’s a requirement. I should maybe have mentioned it’s for small businesses, but still up to 250 employees. It’s fairly large. There’s no better employee scheme really in this country or in the west than the EMI scheme. Because they only the only get charged 10% capital gains at the point of sale.
What’s the direct benefit to the company? Obviously there’s an indirect benefit, but the direct benefit is a corporation tax deduction at the time of exercise. What happens is, and when the next slide is the valuation. Maybe I’ll mention the corporation tax deduction at the end of this because it’s linked to the EMI valuation.
So you might have heard of this before. It’s something we offer at SeedLegals. You know, we will deal with the valuation, the scheme itself, the grants, the subsequent valuations. But really it’s the first stage of the process and probably the most important stage of the process. Our valuation team, for example, you would meet with them. You generate a valuation report for the company and you would send that valuation report to HMRC with the sole intention of getting a low figure rather than a high one. So it’s very different to when you use your valuation and you’re approaching investors.
The purpose here is that it’s gonna set the strike price or exercise price, towards using the same thing, but it’s gonna set that strike price for your employees when they exercise their options. And so if we’re doing this, you know, to keep your staff happy, if we’re doing this to motivate, retain them, and just basically keep them engaged, we want to give them the best possible deal. And that’s why the valuation point is so, so important. And so the things we look at are share transactions, accounts, are you pre-revenue? What’s the story behind the company? You know, why are you doing what you’re doing? What are the challenges you’ve faced? And really, the starting point is the share transactions.
So let’s say you just closed a round. Let’s say you’ve just raised around a 5 million pound valuation, just closed a round. You raised 300,000 pounds, whatever it might be. That would be the starting point for HMRC and our valuation team. We then knock that, applying various discounts that we send to HMRC. So typically a discount is in the region of 60 to 80% of the most recent share issue price. That tends to be the general ballpark figure for those discounts. Things like have you raised EIS or SEIS funds? Why is that? Because your investors have received tax relief. Therefore the valuation must also receive some sort of benefit. Are we stripping dividend and voting rights on the shares? Other shares less valuable? All these things we do as a team to bring that evaluation down so that when it’s time for the employees to exercise their options after their vesting period, they can do so at a very low cost. There needs to be a cost there because of the tax benefits HMRC is given, but at least they get a very low cost at that point.
So that’s why the EMI management is so important. And then going back to that corporation tax point that I mentioned earlier. What happens is at the time of exercise, the employee is going to exercise their options, so purchase shares basically in the company for a hugely discounted price, the valuation versus the market value of those shares four years later will be much higher than the strike price agreed in the valuation today. And so that discount, that difference, is money not received by the company in the eyes of HMRC. So you receive corporation tax relief on that difference. It’s a little bit complicated. If there are any questions about just at the end, but yeah, that’s a direct benefit for the company other than, you know, the motivation of your staff and the retention of your staff. There’s a direct financial benefit, which in most cases ends up being a lot higher than the cost of setting this up. But yeah, the valuation is probably the most important step and I’m sure there’ll be a few questions on that. There’s definitely the most complicated part of the process. So by all means at the end, ask me anything, ask me.
Non-EMI. This covers basically anyone. So I mentioned EMI scheme for your employees, for your UK-based full-time employees. Anyone else – so you know if we’re trying to motivate anyone else, either the international employees, don’t attract consultants, advisors. If you’re trying to get them on board, particularly before Christmas, you use that unapproved scheme. It’s a great name in my opinion. But that is the name of it.
Why is it called unapproved? It’s because you’re setting up an option scheme that’s not approved by HMRC. That’s the only reason that. And the reason it’s not approved by HMRC is because there aren’t any specific tax benefits of it unfortunately. Not everyone’s gonna receive EMI tax breaks. But what it does is that you can use it to motivate your consultants and advisors. It comes from the same option pool and it’s extremely easy and flexible to set up because you don’t have to go through HMRC. So you don’t do a valuation. You simply set up a contract, issue your options to an advisor, whoever that might be, options with vest over, yeah, a period of time as you wish. They sell, each of them will sell. They don’t care about the process. I won’t get too much detail, but if you do have questions just ask me at the end.
My next two slides are about vesting because I’ve mentioned it a lot of times and I’m sure maybe a few questions on those.
As I mentioned, the first step of this process was evaluations returned. We’re issuing that option contract. The reason you have the reason you set up options is because we want to keep as much control with the company as possible. That’s kind of the ultimate, yes. We want to motivate our staff. Yes, we want more people to be engaging the company, but we’re not going to do this unless there’s an element of control there and that we know whoever’s going to end up with this equity deserves it.
Time-based or mile-based milestone-based is the first thing to think about. Typically options will just vest naturally over time. Period of time tends to be four years. I see three I see five but four is by far the most common vesting annually over four years. What that means is say if it was an annual frequency of 4,000 share options say granted at the beginning, that’s 1,000 options vested each year.
Vesting could be kind of the term vesting could be interchangeable with earning. They’re basically earning the rights to the equity over a four year period so by the end of year four, they’re fully vested. And that means definitely vested they’re fully vested if they stay with you four years and that’s a big deal.
Milestone-based is you have a bit more control over that so this can be anything you want, you know say if you had an advisor coming on board. You didn’t really know how long the advisor is gonna be on board, but they are coming on board to do a certain thing whether that might be helping you find investors for your next rounds or maybe you’re bringing on a head of sales who has very clear revenue targets and you want that person, you want that person to achieve milestones. Milestones are a great way of incentivizing someone.
Instead of saying you know, your options are going to vest naturally over a period of time you just say you’re going to get 1.5% of the company as a head of sales. You’re getting 1.5% But only as and when these revenue targets are hit or for example, the advisor, I mentioned these because revenue, funding rounds, closure of funding rounds, you know, X amount committed they can be anything you want them to be as long as they’re measurable and that’s why numbers usually work best but it’s a great way to incentivize people.
Cliff periods – I’m sure maybe a few have heard this idea that if they left any point before the end of this period they don’t get anything. Vesting starts from day one, but we introduce say a one or 18 month cliff, which again is very typical but that means that they leave the company at any point for the first year for the first before the 18th month. They don’t get anything. They’re not entitled to anything because they left for the cliff period. You can make this as straight as you want or as lenient as you want, but there tends to be about 18 months.
Acceleration – This is just for example if they’re on that same vesting schedule and 18 months in unexpectedly a sale happens – are they entitled to the full four years you’ve allocated? They hadn’t actually had time to vest for four years but a sale has happened. And that’s a question whether it’s yes, no or something we would walk through as part of the onboarding process.
And finally, probably the most important one – exercisable. So once vesting is complete after that fourth year, they’re still with you and they’ve, I mean, they’ve fully vested their options. They’re entitled to that equity. They have completed the vesting schedule. However, you can change the further the date of exercise and so on. What I see in most cases is exercisable at any time or on exit. Any time is once they, once the options are vested, so say after the fourth year, they can exercise their options, become a shareholder and sit on the cap table. They’ll be happy, they’re actual shareholders. They’re able to exercise their options. As I mentioned if it’s an EMI option at that point, it would pay the company strike price agreed in the valuation four years ago. Hopefully that’s a really low figure but probably more often see is that this point, the exercise point, is deferred until exit.
Why? A big reason from your perspective as a founder: do you really want to be dealing with loads of employees exercising their options at different times randomly through the year? You are already dealing with enough, you don’t really need to be dealing with that. It’s tedious. It’s something we help with obviously but there’s notification requirements to HMRC. There’s companies house filings to be done. And if you have a team of 10 plus that can become a burden. That’s when it’s one or two, it’s probably fine. But when you grow that team it makes a lot of sense just to keep it as exit only.
Typically we probably strip dividend and voting rights so practically for them, it doesn’t mean much to be able to exercise before an exit anyway. Yeah, they’re in it for the sale proceeds. They don’t really mind if they’re not sitting on the cap table as a shareholder in the meantime. And so it’s in most people’s interest.
Sometimes investors actually don’t want to see a cap table clogged up with employees. That’s not in their interest, you know. That’s capable of harming valuations from a cap table or valuation perspective. And so most of the time EMI schemes we set up exit only. I think with the unapproved scheme it varies a bit more. You know advisors sometimes want to be on the cap table. Sometimes the founder wants the advisor on the cap table because their advisor looks good when they’re looking for investment. But on the other side of that coin, there’s tax implications on the unapproved scheme and sometimes it’s best left for exit. They can just park everything until the company sells.