Options vs. Restricted Stock in the UK— which is best?
This post is not and cannot be considered as legal or tax advice — proper legal and tax advice should be sought in respect of the content covered in the blogpost. Seriously.
Most venture-backed companies incentivise employees and advisors with equity in the company. These schemes typically take the form of either Share Options Schemes (which can be an Unapproved or EMI scheme) or else Restricted Shares. With the caveat that I am not a tax or a legal professional, and that I’d always recommend taking tax and legal advice, here is how they usually work.
Unapproved Share Options
Share options are the right, but not the obligation, to buy a share at a pre-agreed price, called the strike price. Buying the shares is called exercising your options. This means that you have paid for your shares, and you now own them to dispose of as you wish.
Unapproved share options are normally subject to income tax on exercise, but not before, as long as they weren’t granted at an undervalue. If the options are in the money at the grant (i.e. the share price is worth more than the strike price at grant, then the difference could be subject to tax, but this is unusual so we won’t discuss it further here). Generally speaking, when the options are granted (and when they vest over time) there is no cash outlay or cost to the employee or individual. This is why options are the standard for equity compensation packages, as it doesn’t require individuals to find and then spend money on equity that may end up being worth less than they paid for it.
However, at the time an individual sells his or her options, income tax is due at the individual’s marginal income rate (up to 45%). In addition, the options are also subject to the employee’ s and the employer’s national insurance (costing the company 13.8%) on exercise — but this can be elected as an employee cost which increases the rate the employee pays on exercise.
Typically, individuals make the choice to exercise their options and sell them on the same day. If they decide to do this, they will pay tax on the difference between the strike price, and the proceeds.
For example, Jane Doe is granted 10,000 options at a strike price of £1. Lets assume her options are fully vested, and have a fair market value of £30. She decides to exercise her option and sell them on the same day. The amount subject to income tax and national insurance is £290,000.
(10,000 options * £30 fair market value) less (10,000 options * £1 strike price) = £290,000.
However, Jane may decide to exercise her options to buy the shares and hold them. In the same scenario, let’s say she exercises her options and spends £10,000 to buy her shares. She still owes income tax on the difference between the exercise price and the fair market value of the shares at the time of exercise, even if she hasn’t taken a profit. At the time she does sell (if not on the same day as the exercise price), she will owe capital gains tax at highest marginal rates (currently up to 20% in the UK) on any further increase in price.
Let’s imagine that she exercises her share options when the fair market value of the shares is £30/share. She pays the tax on her “profit” even though she didn’t sell the shares. The shares may then go down in price but the tax is still due. However, let’s say that the shares continue to rise in price, and at the time she decides to sell, they are trading at £100/share. She will have already paid (income) tax on the first £290,000 of “profit”, and will owe Capital Gains Tax on the remaining £700,000.
Note — the scenario above, where someone decides to exercise their options without selling their shares, is very unusual, as it triggers a taxable event on an unrealised gain. However, any gains after exercise are taxed at GCT, which is typically lower than income tax.
Here is a good primer from Taylor Wessing on how unauthorised options work if you want to dig a little deeper.
Enterprise Management Incentives (EMIs)
This is a type of UK Inland Revenue approved option scheme designed for smaller companies. It is a formal scheme and must be agreed and registered with HMRC and is subject to stringent qualifying tests. Here is the HMRC overview. It has several tax advantages, although they can be lost over time as the company grows. I reiterate again the need to take proper legal and tax advice here.
The advantages to EMIs are that there is
- No income tax on exercise for qualifying employees
- No employer’s national insurance
- Capital gains is 10% on sale of the shares (subject to a £10m limit)
Note — Advisors can only be granted unapproved share options or restricted stock, as EMIs are only available to employees.
Restricted Shares
Restricted shares can either be granted, i.e. the company grants them to the employee as a form of compensation, or else the individual can buy the shares outright.
Restricted Share Purchase.
Most commonly with restricted shares, companies will give individuals the opportunity to buy restricted shares outright, usually at set price agreed with HMRC. Because the shares have restrictions (e.g. no dividend or voting rights, the individuals have to be employed for x amount of time or they forfeit the shares, etc.) and the company is at an early stage, ordinary shares are typically relatively inexpensive, and individual may choose to buy them. However, this still causes an individual to have to find cash today for a share that may be worth nothing in the future, and that is likely to be illiquid for a long time. The advantage is that profits on restricted shares are taxed at CGT, which is usually less than income tax if you’re a higher rate tax payer.
Restricted Share Grants
Sometimes, restricted shares will be granted outright by the employer. However, the employee still needs to pays income tax at the highest marginal rates (up to 45%) when the shares become available, plus they are also subject to employer’s national insurance (costing the company 13.8%), but this can be elected as an employee cost which increases the rate the employee. Even if you are on PAYE, you will need to fill in self-assessment tax return for that year and pay the tax.
As these costs are payable the year the shares become available, it’s typically problematic for employees or individuals who need to find the cash now even though the shares may not be worth anything in the future.
Then, at the time of sale, restricted shares are normally subject to capital gains tax at highest marginal rates (up to 20%) on sale.
Which to choose?
Obviously, it depends on your circumstances. Everyone’s position is different and circumstances should be considered on an individual basis — tax and legal advice should be sought with regards to your particular situation.
In the case of restricted shares, whether granted or bought, individuals usually owe capital gains tax on their profit. Assuming you’re a higher rate tax payer, capital gains tax is generally lower than income tax + national insurance, so this is usually the most advantageous from a tax point of view. However, in my personal view, this is generally outweighed by the disadvantage that the individuals needs to find money to buy the shares now, when they can’t easily be sold on if they need liquidity, and their investment may be worth nothing later on in time. Venture is a risky business, and employees and advisors who join early stage start-ups are already taking a (calculated) risk by joining an early stage startup. In my view, options allow them to participate in the upside of company growth, without incurring a liability before there is a profit to be taken — even better if it’s an EMI scheme, which offers all the benefits of options, with the tax advantages that reward early employees.
With thanks to Graeme Burnam of Complete Accounting Solutions and Sarah McConville of Jagshaw Baker who kindly reviewed a draft of this post.
