A Key Decision for EMI Option Schemes: Time-Based or Exit-only Share Exercise, or a hybrid?

When you set up your EMI option scheme you need to consider when the employees can actually buy their shares. You actually have quite a lot of flexibility. 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 or exit-only exercise. Just a couple of simple examples: under a time-based scheme you might have 100 options granted today and they’re 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-only 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.

A third structure is a hybrid – an exit-only exercise but with time-based vesting.

Time-based

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, perhaps a very early 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 any sort of exit because they may well be getting dividends if 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 shares as well, and even non-dividend. We can arrange this as part of our service if required.

Exit-only

Turning to exit-only schemes, probably 70% of our EMI clients use such a structure. Exit-only vesting and exercise is good if you want your people focused very much on building value and on an exit event, 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 business, in the team, is focused on the end game which is selling the company for a good return and everyone looks forward to that and getting a good capital gain. In practice, the employees will exercise their options and buy their shares on the day that the company sale is completed, and sell their shares to the buyer alongside the rest of the shareholders.

Hybrid

This structure is becoming more popular especially with tech companies. This has the options vesting over four years with the first year being a “cliff”. However the options can only be exercised on an exit event. Under this structure the employee would not vest any options in the first 12 months, and then 25% of the total options would vest on the first anniversary of grant date. During the next three years the remaining 75% would vest equally on a monthly or quarterly basis.

If an exit occurs before the fourth anniversary, the employee can only exercise those options that have vested by the exit date. Some companies do however allow for “accelerated” vesting, where all of the options will vest on the exit anyway.

If an individual leaves the business prior to an exit and they are classed as a "good leaver", they may be allowed to exercise any options that have vested by their leaving date, unless they depart in the first 12 months ("the cliff" meaning they lose all their options). The definition of good leaver varies widely, but will typically include being incapacitated or being unlawfully dismissed. If the employee is a "bad leaver" he or she will not be able to exercise any options unless the board decides otherwise. A bad leaver will usually include anyone who resigns to join a competitor, or who is dismissed for gross misconduct.

Performance targets

Each of the structures can be combined with performance targets. When you set up an EMI scheme, the agreement will state the maximum number of options that are granted to someone. The actual number ultimately exercised can be lower than that and the number of options that can be exercised will be determined by the level of achievement against performance criteria such as sales targets.

Performance targets must be designed very carefully, or over time they can become a disincentive which renders the option scheme unattractive to your key people. Most companies tend to view performance targets as short term criteria more suitable for bonus schemes rather than share options.