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Motivate your team with share options: how to choose vesting and exercise rules

Motivate your team with share options: how to choose vesting and exercise rules

For this post, we hand over to the share option scheme experts. Kirsty MacSween is a writer at SeedLegals, the one-stop platform for all the legals you need to get funded and grow your business. They take the hard work out of granting and managing share options, and have helped thousands of companies set up their schemes - all for much less than the cost of traditional lawyers and accountants.' 

In our last article, we covered all the reasons why a share option scheme is a powerful incentive to attract and retain talented employees. Now we want to go into more detail about how exactly to structure your scheme.

What choices do you have? What impact will they have on your employee and your company? How do you get started? 

Let’s go ahead and break down your options here. 

Option scheme 101

Here’s a quick refresher of the share option terminology it’s useful to know:

Share options - also called stock options in the US. Share options give the holder the right to buy shares in the company for a fixed price at a fixed time. When companies choose to  give equity to their employees, it’s more common to grant options, not shares. One reason for that is because it’s easier to attach certain conditions to the grant through a share option scheme. 

Option pool - companies put aside a percentage of the company’s fully diluted shares in an option pool for employees and other members of the team. When the company grants options to an employee, the shares come from this pool when the options are exercised. 

Grant or issue - the act of giving employees or others the right to purchase shares in a company in the future through options.

Vest - the process through which employees or other option holders earn the right to exercise their share options. Typically, options vest over time or are earned by achieving specified performance milestones.

Exercise - when employees ‘exercise their right’ to buy shares in the company at the pre-agreed price, after they have satisfied the vesting conditions. Companies can set limits on when employees can exercise their options and actually become a shareholder. 

Exercise 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 (usually at a discount) and doesn’t change over the life of the options.

EMI option scheme - EMI stands for Enterprise Management Incentives. It’s one of the UK government’s approved equity schemes, which means it comes with some tax benefits as well as some rules on granting, vesting and exercising options

Unapproved option scheme - this is a general term for a fully customisable scheme that isn’t one of the HMRC’s approved schemes.

The scheme rules reward employees for great work, while protecting your company equity

The rules in your scheme serve two purposes. By providing the framework under which your team earns their option allocation, you:

  • incentivise loyalty and achievement and
  • protect the portion of company equity in the option pool 

The vesting and exercise conditions you set in your scheme prevent employees from immediately buying and selling ownership in the company. Instead they have to wait a certain amount of time or reach specified milestones to access their options and buy their shares.

By customising the terms (ie, the rules), you can make it work in the best interests of your company and your employees. 

Let’s break down the most important terms you might want to consider for your scheme. 

Vesting cliff: when do employees start earning options?

It’s common for companies to add a vesting cliff to their share options schemes. 

This means that employees don’t actually start earning options until they have worked for you for a set period of time. If they leave before the cliff, they don’t earn any of the options they have been allocated. 

A cliff helps make sure that you‘re not losing equity to someone who only stays for a couple of months, and doesn’t contribute enough value to the business.

The most common vesting cliff we see at SeedLegals is 12 months - meaning that the employee begins earning options after their first anniversary at the company. 

Vesting period: by time or milestone?

You don’t pay your employees their annual salary in one go. Likewise, it’s more common for employees to receive their option allocation in batches over time. 

This incentivises the employee to stay with the company so that they can get their full allocation. If the employee isn’t performing to the standard expected, it also protects the company from losing equity to someone who isn’t adding the value needed.

Your options here are time-based vesting or milestone-based vesting

With time-based vesting, a common vesting schedule would be for options to vest monthly, over three to four years.

You grant your new designer 1,000 share options, to vest monthly over four years.

If they leave after one year, they have 250 options vested.

The remaining 750 options remain unvested and go back to the company.

If they leave after two years, they have 500 options vested.

The remaining 500 options remain unvested and go back to the company.

And so on, until all options are vested.

With milestone-based vesting, you attach a number of options to a performance metric. This can be an individual target for the team member or a company goal.

You grant your new Head of Sales 1,000 share options, to vest in batches of 200 when they hit £500k in sales, £1M in sales, and so on.

How to decide between time-based or milestone-based vesting?

This really depends on your team member’s specific role in your company and the goals you set for them.

Milestone-based vesting can be a powerful motivator to hit targets. But your team must have exceptionally clear, achievable targets that don’t change over the life cycle of the options. 

If the milestones are ambiguous or unrealistic, then options with milestone-based vesting might demotivate and disempower your team - the exact opposite of what you want to achieve.

For that reason, milestone-based vesting is best suited to shorter-term roles and roles that are responsible for a clear objective. For example, advisors and consultants, and heads of sales and marketing. For more information, head over to this article on how to design a milestone-based vesting schedule

Most companies we work with choose time-based vesting with options being earned every month (rather than quarterly or annually). With these terms, options function much like a salary, which is easier for your team to understand - especially if they’re sacrificing a higher wage at another company in return for ‘sweat equity’.

Exercise rules: anytime, only at exit, or somewhere in between?

So far, we’ve covered the rules that govern how and when your employees earn their options (vesting). 

But with options, there’s a further step to convert those options into actual shares (exercising).

There are two reasons you might want to put restrictions on when your employees exercise their options:

  1. There’s lots of admin you need to do when options are exercised. Imagine 10 employees are individually exercising 30 options here, 100 options there etc. This can quickly become unmanageable.
  2. After an employee exercises their options, they become a shareholder. This entitles them to all the rights you assigned to the shares when you granted the options. That might mean you have an obligation to provide them with quarterly management reports and get their vote on company decisions. That’s fine for external investors, but it might not be something you want a current employee to be involved in.

Be aware: the EMI legislation has some rules of its own that restrict when options can be exercised. If your own exercise rules conflict with the EMI rules, your employees may lose out on the tax benefits of the EMI scheme.

The rules are:

  • EMI options must be capable of being exercised within ten years of the grant
  • If the employee leaves the company, they must exercise their options within 90 days

At SeedLegals, we make it easy to set exercise conditions. We’ll go through these in detail below.

Exercise anytime

This gives your team the most flexibility, and means they can exercise their options as soon as the options vest. This comes with a heavier admin burden for the company, which might not be a problem depending on how many option holders you have.

Exercise during a fixed annual period

With this condition, you group together all the exercise admin into one period in the year.

Exercise only when the option holder leaves the company

This solves the potential problem of current employees having access to sensitive salary and budget information as shareholders. With this condition, the employee continues to earn vested options, but won’t be able to exercise them until they leave.

Be aware that, at the point where shares in your company have value and your employee could exercise and sell them, you’re effectively incentivising employees to leave.

Exercise only when the company sells

In this model, if someone leaves the company before an exit or sale of the company, they still keep their options, but they can’t exercise them until a sale happens. 

Be aware that this exercise condition might invalidate one of the key benefits of the EMI scheme. Since EMI options have to be exercised within 90 days of an employee leaving the company, it means that ex-employees will not get the tax benefits of EMI options.

Exercise only when the company sells, anyone who leaves the company loses their options

Commonly referred to as an exit-only scheme, this is the most restrictive of all the conditions. Employees have to be with the company until a sale or IPO before getting any value from their options.

From the company’s perspective, this is sending a powerful message that the company is there to reward employees who remain with the company for the journey.

If there’s no exit on the horizon, however, the hypothetical value wrapped up in un-exercisable options might lose their appeal. And you could find yourself losing valuable team members as time goes on. 

How to set up your option scheme 

At SeedLegals, we’ve helped thousands of companies design and run their share option schemes.

We know that there’s no one-size-fits-all approach to your talent. That’s why you can create as many schemes as you need - for example, an EMI scheme for your UK employees, and an Unapproved scheme for your consultants, advisers and non-UK employees.

✅Follow the easy workflow to build your scheme

✅Use our data to make informed decisions about your scheme rules

✅Set default terms for your scheme, customise for individual option holders

✅Get unlimited, expert help from an options specialist

If you have any questions about how to make share options work for your team, give us a call. We’d be happy to help.

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