Startups and more established SMEs have in recent years become ever more able to access a plethora of ways to incentivise key employees.
This article sets out the main points both startups and SMEs should consider when deciding which type of scheme to set up.
One of the more prevalent types of incentivisation has been the use of tax-advantaged share option schemes, which are a popular choice for companies which have received, or are planning to receive, investment from venture capital funds (not least because it enables the manipulation of the valuation of a company pre and post investment).
Bootstrapping / Pre Investment
It may seem strange to think about a share option scheme when you are bootstrapping, but if you are hoping to receive investment from either seed angels or early stage venture capital funds, a share option scheme, even one that has not yet been implemented, gives investors a good indication that key employees may be retained for a period long enough to utilise any investment made, which makes the company more investable.
At such an early stage of a company’s life, it is usual for the founders to give away equity that is sometimes made subject to reverse vesting (commonly known as “sweat equity”). Although this is a perfectly normal and at times commercially unavoidable way of retaining talent, there are other more tax-advantaged solutions.
An HMRC registerable Company Share Option Plan (“CSOP”) allows employees to be granted options over shares in a company up to a value of £30,000. Employees do not have to pay anything until the options are exercised, performance targets can be incorporated into each employee’s agreement and unless certain circumstances apply, the employee can only exercise the options three years after the date of grant thereby encouraging the employee to stay with the company.
Due to the relatively low value of a company’s shares pre-investment, a CSOP can be seen as the most suitable share option scheme to implement at the pre-investment stage because the £30,000 limit per employee is unlikely to be exceeded.
It is very common to see a provision in investment documentation used by venture capital funds that the investee company may (or must) set up a share option scheme. In some cases, it will be a pre-requisite of a venture capital investment that a share option scheme must be set up within a certain time after the investment has completed, although it is rare to see a provision stating which type of scheme must be set up.
Although a CSOP can be set up in the same way as if the company was still bootstrapping, the major issue will be whether the investment has raised the value of the company’s shares by such an amount that it becomes commercially unviable for the company to offer CSOP options because the £30,000 limit for each employee may not be enough to quantify an employee’s worth to the company.
It is therefore more common in this situation to see an Enterprise Management Incentive (“EMI”) scheme set up. Although the rules surrounding the implementation of an EMI scheme are more stringent compared to a CSOP, there are more significant benefits including:
(i) being able to exercise the option at a price that is less than the value of the shares when the option was granted;
(ii) being able to grant employees EMI options with a value of up to £250,000; and
(iii) employees being able to claim entrepreneur’s relief upon the disposal of EMI option share.
In all cases, if the options under a CSOP or an EMI scheme are exercised at a price which is at least equal to the valuation agreed with HMRC, the employee will not pay any income tax or national insurance contributions on the exercise and subsequent acquisition of option shares. Furthermore, the company may benefit from a corporation tax deduction depending on the exercise price of the option.
How we can help?
Buckworths offer a full range of advisory services relating to the implementation of tax-advantaged and non-tax advantaged share schemes including:
(i) negotiating and agreeing a share valuation with HMRC;
(ii) drafting up bespoke share option plans and share option agreements;
(iii) setting up share option schemes via HMRC’s new online portal and notifying any subsequent grant of options; and
(iv) filing the new mandatory annual return relating to all company share option schemes.