It’s the classic problem for ambitious startups: you want to attract top talent to help you grow your business, but you don’t always have the money to pay top salaries. That’s why many startups offer employees equity as part of their employment package.
Of the companies that offer equity to their employees, most choose options rather than shares. At SeedLegals, we’ve helped thousands of companies set up their EMI Employee Option Scheme. And we’re often asked what the difference is between shares and options – and what the right time is to grant these. We’ve turned our answers into this short guide to help you make the best choice for your business.
What’s the difference between shares and options?
The fundamental difference between shares and options comes down to timing. Someone who purchases shares becomes a shareholder and an investor in the company immediately. Buying these shares often comes with certain rights, like voting rights and dividends – when these are given along with the share.
Granting someone options gives them the right to buy shares in the future, but they don’t become a shareholder – or get any rights associated with the shares – until they actually own the shares.
So far, it sounds simple. Let’s break down what the differences are between shares and options across the following four categories:
Shares vs options: what does it mean for company ownership?
Shares give the holder immediate ownership of a stake in the company. Options are the promise of ownership of a stake in the company at a fixed point in the future, at a fixed price. Option holders only become shareholders when their options are exercised and have converted into shares.
Whether you’re granting shares or share options, it’s important to be careful about how much equity you’re giving away.
Do shares give immediate ownership?
Yes. When shares are issued and allocated, the holder immediately becomes a shareholder and is given equity ownership in the company. This means they have all the shareholder rights attached to the share class, such as voting rights, rights to dividends and rights to their share of the company’s assets if it’s wound up, liquidated or sold.
When your company is in its very early stages, it’s more common to give equity in the form of shares when a key C-suite member is hired. You can read more about this in our article about how to give shares to co-founders and team members
Example: Dan is issued and allocated 1,000 ordinary shares that carry one vote per share and the right to dividends. The company has a total share capital of 100,000 ordinary shares (including Dan’s 1,000 shares). This means Dan owns 1% of the company (1,000/100,000), has 1% voting rights, and can receive 1% of the dividends, if dividends are ever paid (few startups pay dividends in the early stages).
When do options give company ownership?
Unlike shares, options by themselves don’t give equity in the company or any shareholder rights. Instead, the option holder has the right to exercise their option into shares at a future date and at a pre-agreed price (the strike price).
One major benefit of giving employees options instead of shares is that you can control and set conditions on when options are exercised. To find out more about the various option schemes available, read up on Vesting, Milestone or Exit-only: which option scheme is right for you
In early-stage companies, options are a great way to reward team members without spending more on salaries or giving away control. After all, the option holder won’t have voting rights in the company before their options are exercised. The promise of shares in the future, however, can compensate for a low salary and act as the carrot that keeps key employees on board.
Example: Alice is granted 1,000 options with a three-year vesting period. When the vesting period is over, Alice has the right to exercise her options and convert them into 1,000 ordinary shares that carry one vote per share and the right to dividends. After three years, Alice decides to exercise her options and becomes a shareholder.
Options are an enormously powerful and often under-utilised tool for attracting and retaining mission-driven talent to a company. Sometimes founders are wary of giving away equity because of economic and voting dilution, but options get around this issue because option holders don’t have the same rights as shareholders until they exercise. Options make up for low salaries and they give employees the ultimate incentive to build the value of your company.
Shares vs options: what’s the difference in payment?
Another critical difference between shares and options is how they are purchased. This difference impacts both the person receiving equity and the company granting it. So it’s important to think carefully about which form of equity compensation to use to avoid problems down the line.
The sections below detail when and how employees pay for shares compared to options.
When do employees pay for shares?
When shares are granted as part of an employment contract, they are often issued at nominal value – for example, at £0.01 per share, or more. If shares are issued at nominal value, the employee spends next to nothing for their shares, and they won’t need to pay any more in the future.
This is different to a funding round – usually when investors purchase shares as part of a funding round, a premium is added to the nominal value.
Example 1: Dan is issued 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 will own them on allotment.
Example 2: David is issued 1,000 ordinary shares at a price per share of £10 (including nominal value of £0.01). David will pay £10,000 (1,000*£10) to the company for the shares and will own them on allotment.
When do employees pay for options?
No money changes hands when options are granted or vested. Instead, the option holder pays the strike price when they choose to exercise their options and convert them into shares. The strike price is usually a discount on the fair market value (if it’s an HMRC-approved EMI valuation) at the time the options were granted. The fair market value is based on the price per share that investors paid in the most recent funding round.
In some cases, the strike price can be below market value – even as low as the nominal value. In these cases, there could be tax implications – more on this below.
Essentially, the option holder needs to pay the strike price to exercise their options.
Example: Alice is granted 1,000 options with a strike price of £20 per option. After three years, when Alice wants to exercise the options, she will need to pay the company a total of £20,000 (1,000*£20).
Shares vs options: how do shares and options vest?
Vesting refers to the period of time over which shares and options are ‘earned’. The holder only fully owns the equity (shares or options) after this period of time has passed.
While a vesting period can be set for both shares and options, in the UK, there’s a typical difference in the ways shares and options vest. Usually, shares reverse vest and options forward vest.
Company shares: what is reverse vesting?
Shares are issued and allotted to a shareholder upfront. If the shareholder leaves the company before the end of the vesting period, they will be forced to sell the unvested shares back to the company – usually at nominal or nil value.
It’s common to see startup founders on a reverse vesting schedule for their shares. It helps avoid a situation where a major shareholder suddenly leaves the company and takes a large stake of equity with them. This can make the company uninvestable.
Example: Dan is issued and allocated 1,000 ordinary shares with reverse vesting on a four-year period. After one year, Dan leaves the company. Because a reverse vesting condition was in place, the company has the right to repurchase the 750 unvested shares.
Employee options: what is forward vesting?
This means that options are earned in batches over time, usually over a period of three to four years. The vesting schedule might also be set up so that the employee has to achieve certain milestones to earn their options. For more information on the pros and cons of different vesting schedules, see Vesting, Milestone or Exit-only: which share option scheme is best for you?
The main principle in setting a vesting schedule for options is that it helps incentivise the employee. The longer they stay with the company, the more options they vest and the more options they’ll be able to exercise.
Example: Alice is granted 1,000 options vesting over four years. After one year, she leaves the company, with only 250 options vested and the remaining 750 options unvested.
Depending on the terms of the option grant, Alice might be able to exercise her vested options at this stage. Companies will often impose limitations, such as a condition that options can be converted only when the entire allocation has vested, or only between 30 and 90 days after the option holder has left the company.
When choosing vesting terms for your employees, focus on what you are trying to achieve. If you are granting sweat equity – that’s equity instead of salary – time-based vesting is usually the most appropriate. Milestone vesting is better suited to external consultants who are delivering specific outputs against a shorter timeline.
Shares vs options: what are the tax implications and benefits?
This can seem complex, but the basic principles of the tax strategies are actually quite straightforward. We’ve simplified it as far as possible, but tax policies change and depend on individual circumstances. When in doubt, consult a tax advisor.
When are company shares taxed?
Generally speaking, issuing and allotting shares to an individual at a discount will result in an immediate tax payment for both the employee and employer.
To assess the market value of the shares, HMRC either uses the price paid per share by investors in the last funding round or the earning per share according to the company’s trading history. The shareholder is taxed on the difference between the market value and the nominal value the shareholder paid. This difference counts as income and will be taxed as employment income. National Insurance contributions might also be due (NICs).
Example: Dan is issued and allotted 1,000 ordinary shares 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 counts as income and is subject to income tax and possible National Insurance contributions as well.
Are company shares ever untaxed?
“But wait,” you might be thinking, “So the taxman says they want income tax on the market value of the shares, but my startup hasn’t raised funds, has no revenue and therefore has no market value. So can my startup just give shares to someone at a nominal value without paying tax?”
Yes, that’s a great point. Early-stage startups that are pre-funding and pre-revenue can give shares to someone at a nominal value without attracting any tax because the shares have no value at the time of the allocation. Individual circumstances may vary, however, so please seek tax advice before making an issuance like this.
How are share options taxed?
No tax is paid by either the option holder or the company when options are granted or vested. But when the options are exercised, the option holder will pay Income Tax and NICs on the difference in price between the strike price and the actual market value of the shares at that time. When they sell the shares, the employee is also liable to pay Capital Gains Tax on the profit (CGT).
Example: Alice is granted 1,000 options at a strike price of £20 per option. Three years later, on satisfying the conditions of her option grant, Alice exercises her 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 is now £100, so Alice now owns a value of £100,000 shares (1,000*£100). She must pay Income Tax and NICs on the £80,000 difference in price between the amount she paid and the actual market value. When Alice sells her shares at £100,000, she will also pay CGT of up to 20%.
Are employee options ever untaxed?
As you can imagine, the actual market value of the shares and subsequent tax burden could be very high at the time of exercise. So how can you make sure options stay attractive for your employees, given the potential tax fallout?
The answer lies in the EMI Employee Option Scheme. The EMI is a tax-advantaged scheme – backed by HMRC – which allows you to give share options in a way that benefits both employee and employer.
The idea is that the company agrees on a market value with HMRC at the time the options are granted. When the options come to be exercised, the option holder doesn’t pay Income Tax or NICs, provided the shares are exercised for at least the market value they had when the options were granted. Capital Gains Tax is also capped at 10% when the shares are sold. The company pays no tax on the options.
Is it better to grant shares or share options?
In most circumstances, we recommend that you set up a share options scheme when you want to reward your employees with equity. There are various tax advantages when you use an EMI scheme, and a scheme allows for flexibility in setting terms around vesting and exercise.
You might have heard that setting up an employee options scheme is expensive, difficult and time-consuming. Here at SeedLegals, however, it’s simple to create the documents you need in a couple of clicks and manage your scheme online yourself – and we’ll help you at every step.
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We set up more EMI option schemes than anyone else in the UK. Book a slot now to talk to one of our experts.