If you’re a startup founder, you’ve probably heard the terms Share Option Scheme more times than you’ve had to pivot your business model. If it’s left you scratching your head, Cake Equity is here to help you understand how Employee Option Schemes work, in collaboration with our expert legal partners, Sprintlaw UK.
HMRC data shows an increasing number of startups are setting up Employee Option Schemes to offer options to attract new talent or retain, motivate and engage key team members.
Before we dive into the raft of benefits aan Option Scheme can provide, let’s explore the nuts of bolts of how they work.
What is an Employee Share Option Scheme?
A Share Option Scheme is a way to give equity (or ownership) to an employee.
Under a Share Option Scheme options to purchase shares are offered. Because it’s less of a mouthful, we just call these ‘options’.
At a high level, an Option Scheme works like this:
- the employee or contractor receives options (or rights) and becomes an option-holder
- who can be issued shares
- as long as they comply with the rules of the scheme
Is a Share Option Scheme Good or Bad? Hint: they’re great!
Benefits abound for both the company and the employee receiving options. To name but a few…
- Attracting Talent: It’s no secret that cash can be tight for startups, which makes it hard to pay top dollar for talent. Using an option scheme, start-ups can offer tasty equity incentives to top-up slightly lower remuneration packages. The same applies for attracting experienced advisors and developers at an early stage. Knock their socks off with your idea, incentivise them with options.
- Retaining Talent: It’s hard to attract top talent and even harder to keep it. Options are usually subject to vesting, which encourages sticking with a company until the options vest. That’s why it’s often called “sweat equity” – team members need to put in the blood, sweat and tears in order to convert their options into shares.
- Opportunity for significant employee financial gain: An employee can benefit from the increase in value of the options over the company lifetime. It offers hungry employees the chance to generate real wealth through hard work, rather than an outlaying funds from their own pocket.
- Tax Effective: Share Option Schemes can create significant tax benefits for the employees receiving options. More on this below.
- Incentivisation: Potential ownership of a slice of the company means employees start thinking like business owners. It’s common to see a spike in collaboration, productivity, and innovation when option schemes are incentivising the team.
What type of option scheme should I set up?
There are a range of tax-advantaged option schemes you can set up in the UK.
EMIs are most popular for awarding equity to team members (with 84% of the companies offering EMI schemes in the UK) because it has the greatest tax-advantages. If your company is eligible, it’s usually the recommended option.
Other plans include:
- Share Incentive Plans (SIPs)
- Save As You Earn options schemes (SAYE)
- Company Share Option Plans (CSOP) and
EMI Schemes, Explained
So, are you eligible for an EMI?
The basic qualifying criteria that HMRC require be met are:
- The purpose of the EMI must be to retain or recruit employees and not to simply avoid tax.
- You should only intend to grant any one employee a maximum value of £250,000 in options.
- The most a company can grant is £3m in unexercised options at any one time.
A company then must meet the following criteria to be eligible to implement an EMI scheme:
- It must be independent. More than 50% of the ordinary share capital must not be owned or controlled by another company, either now or in the future.
- If the company has any subsidiary companies, they must also qualify for EMI.
- The gross assets must not exceed £30m at the time of EMI options being granted.
- It must have fewer than 250 full-time employees.
- It must have a permanent residence in the UK.
- The business may not participate in one of the disqualifying industries which include financial activities, property development, farming, or shipbuilding.
Finally, employees (including Directors) must also meet criteria to participate in an EMI scheme:
- They must work at least 25 hours each week or devote 75% of their total weekly working time to the company.
- They must not have a beneficial or controlling interest, directly or indirectly, of more than 30% in the company, either now or in the future.
How is an EMI Share Scheme taxed?
Tax treatment can be a beast to get one’s head around, so we’ve broken it down for you as follows:
- Tax is payable on exercise (not upon grant or satisfaction of vesting criteria) where the exercise price is lower than the market value of the shares upon grant of the options. Income tax is then payable on the difference between what is paid to exercise the options and what the options were worth when they were granted.
- Tax is not payable if the exercise price is equal to or greater than market value at the grant.
- Capital Gains Tax (CGT) is payable upon the sale of any exercised options.
- EMI legislation demands that any restrictions on shares acquired after exercise of options must be set out in the EMI Option Agreement. If they aren’t, the Option Agreement can be deemed invalid and the employee may lose tax benefits.
The main benefit to the employee is not paying National Insurance or Income Tax, as they would if they were issued shares outside of this scheme, so it’s super important to follow the EMI legislation closely, to make sure you don’t disqualify employees.
All the FAQs on setting up an EMI
What documents need to be prepared?
The primary documents are Option Scheme Rules and the Individual Offer Letters to option recipients.
Cake has developed template documents using the UK’s best practice principles. But if you need extra help with the legals, Sprintlaw UK are always happy to assist.
Where do the options come from?
The company creates an ‘option pool’, setting aside options that can be allocated to employees or contractors. Consider this one slice of cake, from which smaller nibbles are then allocated.
The standard option pool size is 10% but it can vary between 5% to 30%. This is always a percentage of the ‘fully diluted’ capital in the Company.
An option pool can be created on a Cake account in minutes.
Do options need to be registered with HMRC after the grant. If so, when?
Yes. Within 92 days of the grant.
Is there a filing fee for registering EMI options with HMRC?
How much will it cost to set up an EMI?
Through Cake, and with direct support from Cake's start-up legal partners, you can get a fully compliant scheme set up for 3-4x cheaper than the usual cost. This cost will include getting your scheme fully automated going forward, so there are no need for further costs each time you want to make an offer.
Who can provide the EMI Approved option scheme valuation?
Only the HMRC can approve a valuation.
Any qualified accountant can prepare a valuation report, which then needs to be submitted to the HMRC to determine the final, approved valuation, which Cake’s expert partners can provide to its customers at special discount fixed fees.
What does the valuation report need to include?
The valuation report needs to include:
- Unrestricted Market Value (UMV): This values all the shares as if they had no restrictions and could easily be bought and sold at the market value company at the time. This figure is used to calculate the maximum amount of options allowable to be granted to an individual (£250,000) or by the company (£3m).
- Actual Market Value (AMV): This will not be higher than the UMV, but may be significantly lower. This is because any shares offered via an EMI will make up a small proportion of the company's total equity, and may not be ready for sale on exercise. The AMV is used to set the income tax point for the shares when they are exercised.
How much does a valuation report cost?
It will vary based on the company size and financials. Get in touch with Cake to be connected with a specialist valuer, who can provide a quote.
How will the process work?
You can file for valuation with HMRC, which takes between 2-4 weeks from start to finish.
If you file for valuation with HMRC you can be confident that the valuation is compliant and therefore provides certainty around tax treatment upon the exercise and sale of options.
What other share option schemes and employee share schemes are available if an EMI is out of the question?
Save as you Earn (SAYE)
- Offers an option price up to 20% lower than market price.
- Employees can select a contract period anywhere between three and five years, where between £5 and £500 of their post-tax salary is saved.
- The money saved is used to buy shares at the option price they were offered.
- If the share price of the company has gone up, they make money from the option scheme.
- If the share price has decreased, they don’t lose any money, they just get all their savings back in full.
Company Share Option Plan (CSOP)
- Employee can buy shares up to £30,000 with no discount on the market value
- As a discretionary option plan, employees who otherwise wouldn’t be offered shares in the company are able to buy them.
Share Incentive Plan (SIP)
- A company can offer free shares, partnership shares, matching shares or dividend shares.
- Free shares allow the company to gift up to £3,600 worth of shares to each of their employees annually
- Partnership shares allow employees to buy shares of up to £1,800 from their pre-tax salary annually
- Matching shares can be matched to each partnership share an employee owns for the same amount
- Dividends from previous years can be used to purchase new shares annually.
Need help setting up an share option scheme?
We’re not going to lie, setting up an share option scheme can be a headache if you don’t have the right support.
Cake Equity’s platform automates a significant amount of the process, on average taking 85% less time and costing 90% less than the average DIY equivalent.
Our share option scheme features allows you to plan, approve, implement, issue and manage your share option scheme in minutes.
If you liked this article, check out our comprehensive ESOP guide for founders.
This blog is designed and intended to provide general information in summary form on general topics. The contents do not constitute legal, financial or tax advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.