11 Jan

A Key Decision for EMI Option Schemes: Time-Based or Exit-based Share Vesting?

There is a major decision here for a scheme but just to remind you of the jargon – when you first set the scheme up and award the options that is granting the options and then the actual shares can be bought when the options are vested. Not all of the options have to vest at the same time. When the options have vested and the employee buys the shares that is known as exercising the options.

Essentially, there are two types of vesting structure for an EMI scheme, time-based vesting or exit-based vesting. Just a couple of simple examples: under a time-based scheme you might have 100 options granted today and configured such that 50 options vest after one year and the other 50 vest after two years, i.e. on the first and second anniversaries of the date of grant.

Under an exit-based scheme, an option holder cannot buy the shares until the company goes through what is called an exit event. That is something like a trade sale, a management buy-out or potentially a flotation; it usually involves a change in control of the company from one owner to another. The maximum time any EMI scheme can last is 10 years - even if there is no exit by then.

A time-based scheme where the options vest over a certain period is possibly good for a very senior employee, or someone who is perhaps almost like a co-founder of the company, or very early stage key employee. The founder still owns all 100% of the shares but wants to give his or her senior colleague 25% of the shares, let us say. But then the founder also wants to make sure that the colleague stays with the company for some time. So perhaps grants the option for the options to vest over, say, a three-year period, vesting one-third of the options on each anniversary over three years.

Another common use of time-based options is where the company is looking at a sort of dividend-type income plan for shareholders, rather than selling the company. So it makes sense for an employee to buy shares prior to an exit if they can receive dividends because the company is generating a lot of cash.

One of the issues with a time-based scheme is that the company may need to put a different share class in place. For example, a “B” ordinary share class that gives the board the ability to buy back any shares that have been purchased by employees who then leave the company; the B shares could also be non-voting and/or non-dividend shares as well. You would normally need new articles of association for this – which is not a problem, we can do those. But it is just a little bit more complexity.

Turning to exit-based schemes, probably 70% of EMI clients use such a structure. An exit-only scheme is good if you want your people focused very much on building value with a view to a company sale, with no distractions. So everyone knows what the goal is, and exit only schemes are particularly common in high-tech companies, fast growing companies, and early stage companies. Everyone in the company, in the team, is focused on the end game which is selling the company for a good profit and everyone looks forward to that and getting a good capital gain. It does also avoid having employee shareholders prior to an exit event.

Both types of structure can be combined with performance targets. When you set up an EMI scheme, you have to state the maximum number of options that are granted to someone. The actual number ultimately exercised can be lower than that. The option holder can purchase the number of shares 'earned' against the targets, up to the maximum, when the exit event is achieved or over a period under the time-based scheme. A note of caution however: it's advisable to think hard before using performance targets in an option scheme. Bear in mind that most option schemes have a life of several years, and targets can become a disincentive if the targets become impossible to achieve because of unforeseen changes in the business.