24 Jul

Why is EMI the best share option scheme?

You may be a start up, early stage or several years into the company growth journey but at some point every entrepreneur will sit back and try to work out how they can incentivise their key employees (or sometimes the entire team) beyond just a salary, free coffee, culture and warm words. Most business people will have heard of share options and have an idea that they can be a great inspiration.

Especially in small but expanding companies, options can help focus employees on the longer term goals of the business, beyond their current salary, bonus and promotion prospects. You may be the founder, still holding a majority of the shares in the company, and you're probably aiming for a lucrative exit in three to seven years or so; you're very determined, committed and, I'm sure, excited by the prospect. Or you're a small bunch of shareholders, but the principle is the same.

The big question then is, do I/we want to share some of my/our equity in this business with some of the team. Will it enhance their commitment, and reward them and the existing shareholders with even greater value than if we stayed as we were?

Of course many business owners never grant share options and neither do they ever raise any external investment to help grow their company. That's fine, if they never want to grow too big.

How does a share option work? Very simply, the company signs a legal agreement with an employee that gives them a right to buy a set number of the company's shares at a given price at some point in the future. The right to buy the shares 'vests' on that future date, so the employee can buy them immediately or they can wait until a later date, perhaps the day that the company is acquired (an 'exit' event) in a trade sale, management buy out or even a flotation on a stock exchange.

The key point is that the price for the shares (the 'exercise' price) is set now, so that as the company's value grows over time, the option holders can benefit from the profit they make when buying 'low' but (hopefully) selling 'high'. So let's say Julie is granted 20,000 shares under an option contract at a £1 exercise price and 4 years later her company is sold to an even bigger software business at £10 per share. Julie makes a cool £180,000 gain.

The most amazing story I have been told about share options (in the US they call them stock options) is from a guy who was offered a job by Microsoft in 1980. He turned it down because the package included 'only' £40k worth of stock options. By 1998 he would have been worth about £500 million. Oops.

The good thing about share options is that they can help aline the shareholders' and employees' interests. They help to focus minds on a successful outcome, over a period. Usually this is a sale of the business, but it could equally be the prospect of sharing in a healthy dividend income stream once the company has grown to be strongly profitable. Share options give the employees a feeling that they have a real stake in the business. This can really help to engender an inclusive culture, and it's part of the reason that options are very popular in younger, high tech type companies.

Pragmatically, options can also help to recruit staff at salary levels lower than they might attract in other, bigger companies. If your company is exciting enough, a mix of salary, bonuses, share options, free pizza and diet coke or whatever can have the edge on joining some big, bureaucratic multinational.

Option schemes are very flexible in the way they can be structured. Many companies allow options to vest over a period, perhaps so many shares per year over three years. Some are performance based, e.g. on sales targets, but this can be challenging if you're setting up a scheme that covers several years hence. The majority of schemes though have all of the options vesting on the date of an exit event, so that shares are bought on the day of the company sale and then sold alongside the majority shareholders.

So far I haven't mentioned the elephant in the room - tax. Unfortunately any gains made on shares will attract the taxman's interest, especially as an employee because potentially he can get more out of you than if you're not an employee. This is because by default an employee would pay income tax at up to 45% (plus national insurance) on profits on shares in their own company. However, there is a brilliant scheme which removes the tax nightmare and enables eligible employees to pay capital gains tax instead, and at a rate of only 10%. It's called the EMI scheme and it’s easily the best employee share scheme out there.

The first and main benefit of EMI is the array of tax benefits for employees. There is no income tax to pay when the options are granted, or when the options are exercised to buy the shares. When an employee sells their shares, they will keep 90% of any profit. Without EMI, they might keep less than half of it. The company also gets a tax credit which is offset against its year end corporation tax bill.

Second, under EMI we can agree a share valuation with HMRC as at the date that the options are first awarded (‘date of grant’), and that value is valid for ten years. The benefit is that employees can end up paying very little for their shares, and pay no income tax, and thereby make a much larger profit than they would do without the EMI.

Third, the way that the scheme can be set up is very flexible. You can grant options to selected staff such as key management, or to a more widespread number. The only real limit set down in legislation is that options must be exercisable within 10 years. You could use an ‘exit only’ structure; this means that the employees can only buy their shares when the company is sold. Alternatively a ‘time-based’ structure can be used, for example shares can be bought over the three years after the options are granted, rather than waiting until a company sale.

The fourth benefit is that the options provide a very tangible incentive for key employees to stay with the company. The prospect of a significant profit within a foreseeable period strongly encourages retention of staff, especially as most option agreements provide that options lapse automatically if an employee leaves. Because of the potential reward in the future, EMI options can also help to offset or cushion the risks and uncertainties that may be present in an early stage growing business.

Benefit five is that it’s been shown that employees feel much more aligned with the interests of shareholders and the board if they have a tangible interest in the company’s ownership. It can be a great motivator if all stakeholders are working towards a profitable company sale, with everyone focused on building shareholder value.

Finally: a psychological advantage; share options make an employee feel more appreciated, because options are a benefit that can be awarded alongside the usual salary package and they’re about the longer term. It says ‘we want you to stay with us and help grow the business, because we really value your input’.

Jerry Davison