It’s no secret that employees who share their company’s goals are more motivated - and more likely to stay with the company as it grows. The challenge lies in translating that into a practical incentive that aligns employees' interests with those of your company.
That’s where employee share option schemes can be a game-changer for UK businesses. They offer employees the opportunity to own a stake in the company they’re helping to build. As your company finds success and grows, your team’s financial rewards grow with it. It's a win-win situation for everyone involved.
In this post, we’ll explain what share options are, how share option schemes work, and point you in the direction of more helpful resources. Let’s dive in!
Share options are essentially a staggered and controlled way to distribute company equity. With share options, your team gets the right to buy a certain number of shares in the company at a set price within a specified time frame.
Here's how it works: when an employee is granted share options, they don't actually own the shares outright - at least not yet.
Instead, they have the option to buy the shares at a later date. If the company's share price increases during that time, the employee can ‘exercise’ their options and buy the shares at the lower (previously agreed) price, then sell them on the open market at the higher market price, pocketing the difference as profit.
The world of share options isn’t as complicated as the specialised terminology might lead you to believe. Here’s a translation from legalese of the terms you need to know:
Share option or Stock option - shares and stocks mean the same thing. Share is more common in the UK, while stock is preferred in the US. Shares/stocks refer to a unit of company ownership. Share/stock options represent a promise to sell shares or stocks to the option holder at a pre-agreed price, at a specified time.
Grant or issue - the act of giving employees or other individuals the right to purchase shares in a company through an option agreement.
Vesting - the process through which employees or other option holders earn the right to exercise their share options. Typically, options vest over time or are contingent on achieving certain performance milestones.
Exercise - when employees use their share option to purchase shares in the company at the exercise price.
Exercise price or strike price - the price at which an option holder can purchase shares in the company through their share options. This price is typically set when the options are granted and doesn’t change over the life of the options.
Valuation - the process of determining the current value of the share. This is used to set the exercise price of share options and determine their potential value.
Option pool - a set number of unissued shares put aside by a company for the purpose of granting share options to employees or other individuals in the future. The size of the option pool can be adjusted over time based on the company's needs and available resources.
Better tax treatment - unlike normal shares, share options aren’t taxed at the time of grant in the UK. It’s only when your employee exercises and sells on their shares that they’ll pay tax on this benefit. That could make share options a more tax-efficient form of compensation than a salary bump or a bonus.
Plus, if you grant share options under the EMI or CSOP scheme (more on this later), your employees get even more favourable tax treatment.
Buy low, sell high (ideally) - your employee acquires the right to buy shares at a low exercise price, often before your company has much in the way of
revenue. Over the vesting period, your company grows and scales and its share price increases. Your employer gets in early and gets to cash in on the company’s success.
Attract top talent without draining your cash reserves - ambitious, fast-growing companies need the best talent to hit their goals. But they often don’t have the capital ready to fund high salaries. When used to top up salaries, share options can be a powerful sweetener for new hires.
Retain top performers through scheme incentives - replacing a leaver is expensive. But with share options, your team has a real stake in your company and a reason to stick with the company until it’s successful (and they can sell their shares for a high price). You can attach vesting and exercise conditions to your employee’s share options to incentivise staying until the company exits or another milestone is met.
Protect your equity through the scheme’s rules - your company equity is precious and you need to avoid giving away too much too soon or not getting enough value back. Setting vesting and exercise conditions to your employee’s share options is a controlled way to reward your employees while protecting the company’s interests.
Use the tax advantages to lower the cost of compensating your team - certain types of share option schemes, such as the EMI and the CSOP (see below), offer tax advantages that can reduce the cost of granting options to employees.
We’ve covered the basics of how share options work. Now, let’s look at what considerations go into designing your share option scheme.
You can run multiple share option schemes at the same time, with different parameters in place for different team members.
The UK government has two ‘approved’ share options schemes which come with very attractive tax advantages. But, since they also come with some fairly restrictive rules, these won’t be suitable for every company or every member of your team.
By far the most tax-efficient way to grant options to your team.
Employee tax benefits – under the EMI scheme, your employees won’t pay Income Tax or National Insurance when they exercise their options at the price agreed with HMRC. They might also be able to benefit from a lower rate of Capital Gains Tax when they sell their shares.
Employer tax benefits – the company gets a Corporation Tax deduction on the difference between the market value of the shares at exercise and the amount your employee pays for them.
Strict eligibility requirements - not all companies and employees are eligible for the EMI scheme. The company must have under £30 million in gross assets, employ no more than 250 people and not operate in an excluded trade. Employees must work at least 25 hours per week or 75% of their working time for the company - and be based in the UK.
Limits on value of options - the total value of options that can be granted through EMI is capped at £250,000 per employee.
Constraints on setting your own terms - mostly, you’re free to set your own vesting and exercise conditions, but the options must be exercisable within 10 years of the grant.
Administrative complexity - you need to agree a valuation of your shares with HMRC before granting options to a team member. This means you have less control over the strike price your employee will pay at exercise. You also need to keep HMRC involved along the life cycle of the options.
If your company’s too big to qualify for the EMI scheme, CSOP might be right for you.
Employee tax benefits - like the EMI, your employees won’t pay Income Tax or National Insurance Contributions when they exercise their options. They might also be able to benefit from a lower rate of Capital Gains Tax when they sell their shares.
Employer tax benefits – like the EMI, the company gets a Corporation Tax deduction on the difference between the market value of the shares at exercise and the amount your employee pays for them.
Lower total value of shares - the total value of options that can be granted to an individual employee through CSOP (£60,000) is lower than the EMI. You might not find this to be enough of a perk to motivate and keep key employees.
If your company or your team member isn’t eligible for an HMRC-approved option scheme, you can go it alone with an Unapproved scheme. What you lose in special tax treatment, you gain in greater freedom to structure the scheme how you’d like.
Freedom to grant options to any team member - non-UK employees, part-time workers, freelancers, consultants, advisers. Under an Unapproved scheme, you can grant options to each and every member of your team.
No limit on the total value of options granted - unlike EMI and CSOP schemes, there’s no upper limit on the value of options you grant.
Don’t have to agree a strike price with HMRC - with an Unapproved scheme, you’re free to set whatever strike price you want for your employees. That means you could grant options at nominal value of pennies, and not stick to a fair market price at the point of issuing, which could be restrictively high for your employees.
Lower admin burden - no valuation report and less paperwork in general to file with HMRC.
No special tax treatment for employees or employers - to understand how tax will work in your specific circumstances, make sure to consult your accountant or a tax specialist.
At SeedLegals, we’re passionate about how much value share option schemes can deliver back to companies. And we think it’s important that hard-working teams get their own piece of the pie.
We’ll help you:
In a future article, we’ll explore how to choose the right vesting and exercise conditions for your scheme to keep your team motivated - and your company protected. If you can’t wait and are keen for equity insights right now, check out our options resources and our free ebook.