How to set up an employee share option scheme

Employee share option schemes are a type of employee share scheme that has become the go-to way for SMEs and startups to incentivise and reward their employees. This type of remuneration package has become almost expected, especially in the tech industry, where it’s a necessary tool to recruit and retain quality personnel successfully.

These types of schemes allow employees to partake in their employers' success while reducing pressure on the business's cash flow. They provide a balance between the company's growth goals and employee performance that is acknowledged and appreciated by investors of all levels. It’s no surprise why these schemes have gained such wide popularity.

Creating an employee share option scheme for your business doesn’t need to be complicated. In this article, we will discuss the essential elements you must consider and answer to offer share options to your team.

Share options or shares?

When you give share options to your employees, you give them the right to acquire shares in the future, meaning they only become shareholders when they receive the option. 

This means they only become shareholders when they exercise the share option and convert it into shares. Because granting the option doesn’t immediately result in bringing new shareholders on board, it allows more flexibility to the company's management - including the cancellation of the option if the employee ceases to work for the company.

Therefore, from a legal and corporate perspective, granting share options is more efficient for the company than giving shares to employees.

When are share options granted?

Share options can be granted all at once or, what is more common, under a vesting schedule based on the performance of the employees and how long they have been working for the company. 

Provided that the share option scheme is set following the employment rules about equality, you can tailor the vesting schedule to the roles and targets of each employee. 

When can employees exercise their share options?

The share option exercise is when employees convert their options into shares.

If you plan to exit your business in the near future, the exercise of the options is quite often linked to that exit. When you sell your business, the employees can exercise the option and convert it into shares that will be sold together with the shares of the other shareholders. 

For businesses that don’t plan to exit, it’s common to set the exercise of the options some months or years after the date when the options were granted - depending on when you want your employees to participate in the distribution of dividends.

In both cases, consider setting other conditions for the exercise of the options based on the employee's performance and the achievement of specific targets or KPIs of the company. 

Which and how many shares shall be allocated to a share option scheme?

You don’t need to grant your employees options over the same class of shares you or your investors have. 

You may consider using a different class of shares to serve the share option scheme. For example, you may define that the options will only relate to non-voting shares or to growth shares that only benefit from the company's growth after a specific hurdle price. 

Regarding the number of shares, it may be easier to first think about what percentage of your company's share capital you are willing to give away to serve the share option scheme. 

Then, based on that and on the number of shares the company owns, and, if seeking investments, how many will be distributed in the fundraising round, it’s easier to calculate the number of shares that each employee will be given in the scheme.

What happens if the employee ceases to work for the company before the exercise?

Good leaver and bad leaver provisions are common in share option schemes, and you have great flexibility to define the rules that will apply to your scheme.

You can say that the share options will always lapse (i.e. will be lost) if the employment contract terminates, that no share options will lapse upon such termination, and pretty much anything in between. For example, share options will lapse only if there has been a breach of contract. 

As mentioned regarding the granting of the option, provided that you comply with the employment rules against discrimination, you may set different bad leaver and reasonable leaver provisions for each employee based on their roles and responsibilities. 

How much does the employee pay to exercise the share option, and how much tax will be paid?

The amount the employees will be required to pay to exercise their share option (called the exercise price or strike price) depends a lot on whether the share option scheme attracts any tax incentives.

The most common employee share option scheme for employees working at early-stage startups and SMEs is the Enterprise Management Incentive scheme (EMI scheme). 

If you want to take advantage of the tax incentives available under EMI schemes, you need to set the exercise price at least at the market value of the share on the date when the option is granted. HMRC will then need to validate this valuation.

Although EMI schemes are still on trend, calculating their tax benefits compared to the advantages of setting a lower exercise price may be a complex task.

How about share option schemes for non-employees?

You can set share option schemes for advisors and contractors who are not employees using the same structure we described for the employees. You will need to go through the same questions mentioned above. However, you cannot use an EMI scheme for non-employees. 

What are the documents required to implement a share option scheme?

After you think about the points mentioned above, you’ll need to put your decisions on paper and formally set up the share option scheme for your employees. 

Share option schemes usually require:

• A set of rules (which will apply to all employees to whom option shares will be granted)
• An option agreement (which will apply to the employee who signs that agreement)
• Corporate document to approve the scheme (which will depend on the articles of association of your company and the shareholders’ agreement you have in place - if any)

To get started with an EMI scheme you can download LawBite’s free EMI Scheme Option Rules template. If you need further support creating a scheme for your business, discover Crunch’s partnership with LawBite and get help drafting all the associated documentation and tailoring it to suit your requirements.

About the author

Carla Caroli is one of LawBite’s expert business lawyers. She has advised hundreds of SMEs on funding rounds, shareholder agreements, option schemes, share capital restructure, loan agreements, guarantees, terms and conditions, data protection documents, licences and intellectual property assignments, and a wide range of commercial contracts.