How to get the best out of share options
This note provides an outline of the steps involved in creating a tax efficient incentive structure using shares for the key people in a business.
A share option is an agreement that the option holder (usually a key person involved in the business) can buy shares in the future. Options fix the price at which the shares can be bought so that the option holder can buy shares at a discount if the value goes up and he doesn’t have to exercise if the price goes down.
The key benefit is that it allows people to participate in an exit (as a selling shareholder) without having to pay for shares before the exit.
In order to do this in a tax efficient way we usually recommend that the options fall within the enterprise management inventive (EMI) regime.
Benefits of using an exit-only EMI option
This type of share option allows the company to grant options without triggering an employment tax charge either on grant or exercise of the option (assuming certain requirements are met) and the company can also claim a valuable corporation tax deduction on exercise of the option.
On the basis that the key incentive will be the right to share the sale proceeds on an exit, we usually recommend that the options are drafted so that they can only be exercised in the event of an exit. This avoids the scenario that the option holders have to find money to pay for the shares before a sale of the shares (which can be used to fund the exercise / acquisition price) and avoids the scenario that the option holders become shareholders and then leave the business before a sale.
Identifying relevant value
The value that he option holder contributes to the business should be understood; for example a sales director should be measured against sales but that would be an inappropriate measure for a CTO.
We can then tie in the value of the option to the contribution made by the option holder. In order to achieve this we would create different classes of shares within the company, each having different rights reflecting the different roles within the business or divisions within the business.
The steps involved in this are:
1. Identify KPIs
The starting point of building an effective incentive structure is to understand how the performance of the intended option holders can be measured.
2. Link KPIs to option value
Determine the link between (a) performance against KPIs and (b) the number of shares over which the options can be exercised. For example the option might give the right to buy 100 x B shares if the turnover of the business reaches a multiple of 3 within 5 years, falling to 75 x B shares if that target isn’t met until year 7 and falling to 50 shares if the target isn’t met before a post-7 year exit.
This could be linked to a wide range of targets related to the business, for example maintaining a particular gross profit target, the business valuation, an EBITDA target, etc or it could be linked to the personal performance targets of the option holder.
Where the purpose of the option is to incentivise the growth of the business prior to an exit, we would recommend linking the performance ratchet to something which reflects the growth in the value of the business.
3. Ensure different business streams are clearly reflected in the financial reports
Tax efficient share options can only be granted in the top company of the group and so we will need to understand the current group set up and, if necessary, bring divisions that sit outside of the main company / group within the main company / group. The way in which the financial performance of each part of the business is tracked in the top company will need to be considered and agreed. This might be straightforward but it is best to be clear so that there are no uncertainties about the extent to which performance targets have been met or missed.
4. Create A, B, C, etc shares
This involves amendments to the company’s articles of association (together with the necessary board minutes, resolutions and Companies House filings) to rename the existing issued shares as A shares and to create new classes of shares with rights linked back to the identified streams of the business.
5. Create share scheme
This involves drafting an EMI compliant share scheme, incorporating the performance ratchets mentioned above, together with the necessary board minutes and resolutions.
Various other terms of the options will need to be discussed and agreed, such as what happens to the option in the event that the option holder retires from the business or becomes too ill to work, and what would happen in the event there is an exit before the performance targets have been reached.
6. Agree share value with HMRC
It is important to understand the market value of the shares that are to be put under option. There are strict requirements as to the value of shares which can be placed under EMI (tax efficient) options and an immediate tax charge can apply if the limit is exceeded. If the company inadvertently exceeds the limit and it is later discovered by HMRC, penalties and interest can apply on top of the tax charge.
On exercise of EMI options there is a tax charge (which falls on the company) to the extent that the exercise price (i.e. the amount payable by the option holder to exercise the option) is less than the market value of the shares at the time the options were granted. It is important to understand the extent of this potential exposure to tax so that appropriate provision can be made in the accounts, or so that the exercise price can be set high enough to avoid this tax charge arising (which is the approach adopted by most companies and is typically recommended).
7. Grant share options
Board minutes and resolutions will be needed to authorise the directors to grant the share options to the key managers.
8. HMRC filings
HMRC has to be notified of the option grant within 92 days of the option agreements being entered into. Following grant of the options the company has annual filing requirements (which would typically be handled by the company’s accountants).
You can go for a quick and dirty share option agreement which will cost a few thousand pounds. What I’ve set out above is tailored to individual roles and the value which is added to the comapny. If you’re looking to use the options to drive a higher exit valuation it is worth spending a bit more to get it right as the quick and dirty route too often leads to a perception (right or wrong) of people walking away with 5% (say) of the sale proceeds without having contributed to the growth of the business.