Most UK startups offer equity compensation to employees in the form of options (by setting up an EMI employee option scheme). Here at SeedLegals, being the number one provider of Employee Share Option schemes in the UK, we often get asked what the difference is between shares and options and when they are the right choice for your business. So here’s our comprehensive FAQ.
What is the difference between shares and options?
The fundamental difference between shares and options is that if someone owns shares, they are immediately a shareholder in the company. If someone owns options, they have the right to buy shares in future.
The nuance of these differences falls into four main categories:
- How do shares and options effect company ownership differently?
- Cash payment: how and when are shares and options purchased?
- What vesting, protection, and employee retention incentives do shares or employee options offer?
- What are the tax implications and tax benefits of an employee option scheme?
How do shares and options affect company ownership differently?
Whilst shares give the shareholder immediate ownership in the company; options are a little more complicated. They allow the individual to become a shareholder at some point in the future once the options have converted into shares.
Does allocating shares give immediate ownership?
Once shares are issued and allocated, the individual immediately becomes a shareholder and is given equity ownership in the company, including all the shareholder rights attached to the shares, such as voting rights, right to dividends, right to the distribution of the company’s assets in the event of winding-up or sale etc.
Example: Dan gets issued and allocated 1,000 Ordinary Shares that carry one vote per share and the right to dividends. The company has a share capital of a total of 99,000 Ordinary Shares. In this case, Dan will own 1% in the company (1,000/100,000) and will also have 1% of the voting rights in the company, and finally, they will be entitled to dividends on a pro-rata basis of 1%.
When do options mean company ownership?
On the other hand, if an individual is granted options, they don’t get any equity in the company nor any shareholder rights. Instead, the option holder gets the right (but not the obligation) to convert his options into shares (known as exercising) at a future date and at a pre-agreed price (known as the “strike price”). The conversion of the options is subject to many conditions, which may never be fulfilled. In practice, the option holder will usually exercise their options on exit since they are liable to pay for them and would only typically do so when they know they will be sold directly after – such as at an exit.
Example: Dan is granted 1,000 options, and after 3-years, they have the right to exercise his options and convert them into 1,000 Ordinary Shares that carry one vote per share and the right to dividends. After three years, once Dan decides to convert his options into shares, they will become a shareholder.
Cash payment: how and when are shares and options paid?
Another critical difference between the two forms of equity compensation is the method of purchasing the shares. This has a vast impact on both the individual and the company, and from our experience, this is not always taken into consideration. To avoid future hiccups down the line, we recommend that you think about this carefully when choosing which form of equity compensation to use.
When do you pay for company shares?
Once shares are issued and allocated, the shareholder owns them. In most cases, the shares are issued and allocated at nominal value – for example, at £0.01 per share (unless it’s part of a funding round where a premium will be added to the nominal value and paid for by the investor). So in practice, the shareholder will spend close to zero for his shares, and they won’t need to pay anything else in the future.
Example: Dan gets issued and allocated 1,000 Ordinary Shares at a nominal value of £0.01 each. Dan will pay £10 (1,000*£0.01) to the company for those shares, and they will own them immediately.
When do you pay for employee options?
There is no payment made when options are granted (or even vested), but instead, the option holder will pay the “strike price” when they choose to exercise his options and convert them into shares. The “strike price” will usually be close to the fair market value at the time the options were granted, which in practice will be similar to the price per share that the investors paid in the last funding round. However, in some cases, the “strike price” will be below market value – and can even be as low as the nominal value of £0.01 per share. In those cases, there may be some major tax considerations (more on this below).
Essentially, the option holder will usually need to come up with cash to exercise his options:
Example: Dan is granted 1,000 options with a “strike price” of £20 per option. After three years, when Dan wants to exercise the options and convert them into share, they will need to pay the company a total of £20,000 (1,000*£20).
What vesting, protection, and employee retention incentives do shares or employee options offer?
Vesting means that the shares or options are ‘earnt’ over a period of time, and the person will own the full amount of the equity (shares or options) only when the full period has lapsed (usually after 3 or 4 years).
Whilst a vesting period can be set for both shares and options, in the UK, there are two distinct methods in which options vest vs shares vest. Options vest by ‘forward vesting’ method and shares vest by way of ‘reverse vesting’, as explained below.
Company shares: What is reverse vesting?
Reverse vesting: shares are issued and allocated to the shareholder upfront, but the vesting mechanism works reversely. So, if the shareholder leaves the company before the end of the vesting period, they will be forced to sell the unvested shares (usually at no profit) to the company. This is a form of protection for the company and helps avoid a situation where a shareholder suddenly leaves the company and takes a large stake with them. This is why companies almost always have founder vesting in place. In startups, this is important. A shareholder that leaves the company with a significant portion of equity may make the company uninvestable in the future since very little equity would be left for future investors.
Example: Dan gets issued and allocated 1,000 Ordinary Shares with reverse vesting on a 4-year period. After one year, Dan leaves. Because a reverse vesting mechanism was in place, the company has the right to repurchase the 750 shares that were yet to vest.
Employee options: What is forward vesting?
Forward vesting: the vesting mechanism for options is forward vesting, whereby the option holder is granted with options incrementally, usually over a 3-4 years period, or in line with achieving business goals with milestone vesting.
This will incentivise the option holder to stay with the company and will keep motivation high. The longer the option holder stays with the company, the more options they will get and the more options they will be able to convert into shares in the future. In early-stage companies, options are relatively cheap and easy to give and do not represent a big compromise for the company. After all, they are not shares; the option holder doesn’t have voting rights or any other say in the company before they convert. They can be used as a great tool to compensate for a low salary, and they are often a carrot that keeps key employees on board.
Example: Dan is granted 1,000 options vesting over a 4-year period. After one year, Dan leaves the company, with only 250 options vested and the remaining 750 options unvested. In certain situations, Dan would be able to convert his options into shares at this stage, but companies will often add some limitations, such as a condition that options can be converted only when they have completely vested, or between 30 and 90 days after the option holder has left the company.
What are the tax implications and tax benefits of an employee option scheme?
One last point to note is the tax implications and benefits. Whilst this may seem very complex, the principles of the tax strategies are quite easy to understand. We have simplified it as far as possible, but tax treatment is subject to change and individual circumstances, so if in doubt, do consult a tax advisor for bespoke advice.
When do company shares become taxable?
Generally speaking, issuing and allocating shares to an individual at a discount will result in an immediate tax charge for the employee and employer. In order to value the shares, HMRC will use the price paid per share (by investors) in the last funding round or the trading history of the company to find out the earning per share. Then the discount is taxable as employment income and PAYE, and NICs may also be due.
Example: Dan gets issued and allocated 1,000 Ordinary and is asked to pay the nominal value of just £0.01 per share. However, since those shares have a market value of £20 each according to HMRC (based on a recent investment round or trading history) – the £19.99 difference would be taxable immediately.
I hear you ask, “Ok, so the taxman says they want income tax on the market value of the shares, but my startup hasn’t raised funds and has no revenues (hence no market value), so can my startup just give shares to someone at a nominal value without paying tax…?”. Well, that’s a great point, and indeed, early-stage startups that are pre-funded and pre-revenue may give shares to someone at a nominal value without creating any tax implication as the shares have no value at the time of the allocation.
When do employee options become taxable?
No tax is paid by either the option holder or the company when options are granted (and even vested), but when the options are exercised (usually after 3-4 years), the option holder will be subject to Income Tax and NICs on the difference in price between the “strike price” and the actual market value of the shares at that time. But not only that, once the shares are sold – the employee is liable to pay Capital Gains Tax (CGT).
Example: Dan is granted 1,000 options at a “strike price” of £20 per option. Three years later, Dan exercises his options and pays the company £20,000 (1,000*£20). However, as the company has been doing very well, the actual market value of the shares in the company is now £100, so Dan now owns a value of £100,000 shares (1,000*£100). The £80,000 difference in price between the amount they paid and the actual market will be liable for Income Tax and NICs. Lastly, when Dan sells his shares at £100,000, they will pay CGT of up to 20%.
As you can imagine, the actual market value of the shares may be very high at the time of exercise after a few years.
So one of the most obvious questions here is whether there is a way to cap this increase in the market value of the shares? And the answer to that question is: Absolutely.
This is where the EMI employee option scheme comes into play. EMI schemes are tax-advantaged schemes that can be highly beneficial for both the company and the individual option holder. The idea is that the company agrees on a market value with HMRC at the time the options are granted, and then when the options are exercised, the option holder won’t have to pay Income Tax or NICs (providing the shares are exercised for at least the market value they had when the options were granted). The company pays no tax on the options at all. Finally, CGT will be capped to 10% (entrepreneurs’ relief) if an individual sells the shares.
How do I set up an employee option scheme?
If you still have questions about options and shares or would like to know more about how SeedLegals can help you give out equity to your team, just start a chat; we’d love to help.
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