What Are Share Options? A Startup’s Guide to How Shares Work

Many entrepreneurs benefit by using share options as a way to reward and keep their top-performing employees. Share options give employees the chance to buy company stocks at a fixed price, which can make them feel more connected to the company’s goals as well as offer tax advantages. So far, so great… however, navigating all the rules and regulations around share options can be pretty tough.

This comprehensive article will explore and explain the world of share options, including their types, advantages, disadvantages, and how they work in the UK.

What are share options? A definition

Share options are a form of employee compensation that gives employees the right to purchase company stock at a predetermined price. This means that employees can buy shares in their company at a price typically lower than the market price.

Business owners often use share options to incentivise and retain talented employees, as they provide a great way for employees to share in the company’s success and align their interests with those of the company.

Share options come in different types, including:

• Incentive stock options (ISOs)
• Non-qualified stock options (NSOs)
• Employee stock purchase plans (ESPPs)
• Restricted stock units (RSUs).

Please note that these options have varying terms and conditions that dictate when and how they can be exercised, vested or expire.

Why are share options important for startups?

Share options are a powerful tool to help attract, motivate and retain talented employees. By offering shares, startups can provide employees with a stake in the company’s success, resulting in a more engaged and committed workforce, and increasing productivity and profitability.

What are the different types of share options?

Several types of share options are available for startups to use as employee compensation. Each type of share option has unique terms and conditions, advantages and disadvantages.

The four most common types of share options are:

• Incentive stock options (ISOs)
• Non-qualified stock options (NSOs)
• Employee stock purchase plans (ESPPs)
• Restricted stock units (RSUs).

Incentive stock options

Incentive stock options (ISOs) are share options that are only available to employees of a company, designed to provide tax benefits to employees who hold the shares for a certain period before selling them.

Pros: Can provide tax benefits for employees and align their interests with those of the company.

Cons: Are sometimes complex and may have strict eligibility requirements.

Non-qualified stock options

Non-qualified stock options (NSOs) are share options that do not meet the criteria for ISOs. They have more flexible terms and conditions and are typically easier to administer than ISOs.

Pros: NSOs can be a cost-effective way to compensate employees and be more flexible than ISOs.

Cons: They may not offer the same tax benefits as ISOs.

Employee stock purchase plans

Employee stock purchase plans (ESPPs) allow employees to purchase shares of the company’s stock at a discounted price. They typically have lower eligibility requirements than ISOs or NSOs, and allow employees to build personal investment portfolios.

Pros: ESPPs can incentivise employees, align their interests with the company’s, and offer tax benefits for employees.

Cons: They may not provide the same financial upside as ISOs or NSOs.

Restricted stock units

Restricted stock units (RSUs) grant employees the right to receive shares of the company’s stock at a future date — they typically vest over time and are subject to certain restrictions.

Pros: Can provide a more straightforward and less complex way to compensate employees, and they can be less dilutive than other forms of share options.

Cons: May not offer the same financial upside as ISOs or NSOs and may not align employee and company interests as effectively as other share options.

How do share options work?

Share options, also known as stock options, are a type of financial instrument that companies use to incentivise employees, executives and other stakeholders. Share options give the holder the right, but not the obligation, to buy a certain number of shares in the company at a predetermined price, known as the strike price.

Granting of share options

The granting of share options typically occurs as part of a compensation package for employees, executives, or other stakeholders. When a company grants share options to an individual, it essentially gives them the right to purchase a certain number of company shares at a predetermined price. The price at which the shares can be bought is known as the strike price, and it is set by the company when the share options are granted.

Exercise of share options

When the holder of share options decides to exercise their options, they purchase the shares at the strike price, which can be done at any time during the life of the share options up to the expiration date. When the shares are purchased, the holder becomes a shareholder in the company and can benefit from any increase in the value of the shares.

Vesting of share options

Share options typically have a vesting period, during which the holder must wait before exercising their options. Vesting is a way for companies to incentivise employees to stay with the company for a certain period. During the vesting period, the share options are not yet available for exercise, and the holder has no ownership interest in the shares. As the vesting period progresses, the share options become available for exercise in increments until fully vested.

Vesting schedules can take many different forms, but they generally fall into two categories:

• Time-based vesting requires the holder to remain with the company for a certain period before the options become fully vested.
• Performance-based vesting requires the holder to meet specific performance metrics before the options become fully vested.

Expiration of share options

Share options typically have an expiration date, after which they are no longer valid. The company sets the expiration date when the share options are granted, ranging from a few months to several years. If the share options are not exercised before the expiration date, they become worthless, and the holder loses their right to purchase the shares at the strike price.

Advantages of share options

Share options offer several advantages for entrepreneurs and startup founders, for example:

Incentivising key employees and executives

By offering share options as part of a compensation package, startups can motivate their teams to work harder and contribute to the company’s growth and success because options help to incentivise key employees to stay with the company long-term.

Conserving cash

Share options allow startups to conserve cash by offering equity in the company instead of money. This can be particularly beneficial for startups needing more cash flow to provide high salaries or bonuses.

Retaining ownership and control

Startup owners can ensure they retain ownership and control of their company by offering share options. This may sound counterintuitive, but startups can maintain greater control over their company’s direction and strategy by offering shares to employees rather than selling equity to outside investors. This approach can also be beneficial if the company’s value increases over time.

Attracting investors

Share options can be used to attract investors to the company because they’re often more willing to invest in a company with a motivated and incentivised team, as it increases the likelihood of its success. By offering share options to employees and executives, startups can demonstrate to investors that they are committed to building a successful company and have a team aligned with their goals.

Tax benefits

In some cases, share options may be eligible for tax breaks (including capital gains treatment) or deferrals, reducing the overall tax burden for the owner and the company.

Disadvantages of share options

While share options offer several advantages for entrepreneurs, there are also some potential disadvantages, including:

Dilution of ownership

Share options can result in the dilution of ownership for startups because, when share options are exercised, new shares are issued and the percentage of ownership that existing shareholders hold in the company is reduced. This dilution can be particularly significant if you’re an early-stage startup because every percentage point of ownership can be critical to the company’s success.

Complexity of implementation

Share options can be complex to implement, particularly for early-stage startups with limited resources. Developing and administering a share option plan can be time-consuming and require legal and accounting expertise. Shares may also need to be granted and tracked over time, which can add to the administrative burden.

Cash flow issues

While they can help startups conserve cash in the short term, share options can also create cash flow issues in the long term. This is because when share options are exercised, the company may need to issue new shares or repurchase existing shares, which can require cash payments. If the company needs more cash to cover these payments, it can create financial strain.

Limited value for employees

Share options may only provide significant value to employees, mainly if the company experiences substantial growth or if the share price increases over time. Employees may also need restrictions on when they can exercise their options or sell their shares, limiting their ability to realise value from the options.

Potential for disputes

If the share option plan is not structured correctly or there are disagreements over the company’s valuation, share options can create the potential for disputes among shareholders. Such disputes can be time-consuming and costly, and detract from the company’s focus on growth and success.

Share options vs stock grants

Share options

Definition: Share options give the holder the right, but not the obligation, to purchase a certain number of shares in the company at a predetermined price, known as the strike price.

Value: The value of share options is derived from the difference between the strike price and the current market price of the shares. If the market price is higher than the strike price, the options are said to be “in the money” and can be exercised for a profit. The options may have little value if the market price is lower than the strike price.

Taxation: Share option holders are generally only taxed once the options are exercised and the shares are sold. The gain from the sale of the shares is then subject to capital gains tax.

Vesting: Share options and stock grants can have vesting schedules, during which the holder must wait before the options or shares become fully vested. Vesting schedules for share options are typically shorter than those for stock grants. Share options are also more likely to have performance-based vesting, which requires the holder to meet certain performance metrics before the options can be exercised.

Risk: Share options are riskier than stock grants, as their value depends on the shares’ market price. If the market price of the shares decreases, the options may become worthless.

Stock grants

Definition: Stock grants provide the holder with actual ownership of shares in the company, usually without any additional cost to the holder.

Value: Stock grants have a fixed value based on the current market price of the shares.

Taxation: The holder of stock grants is typically taxed on the fair market value of the shares at the time of grant, and the gain or loss from the sale of the shares is also subject to capital gains tax.

Vesting: Vesting schedules for stock grants typically have a longer duration than those for share options.

Risk: Stock grants have a fixed value based on the current market price of the shares and therefore carry less risk than share options.

Share options vs stock bonuses

Share options and stock bonuses are equity-based compensation companies use to incentivise employees and executives. However, there are several key differences between the two:

Share options

Definition: Give the holder the right, but not the obligation, to purchase a certain number of shares in the company at a predetermined price, known as the strike price.

Timing: Typically granted at a specific time and have a vesting schedule, during which the holder must wait before the options become fully vested and exercisable.

Value: The value of share options is derived from the difference between the strike price and the current market price of the shares. If the market price is higher than the strike price, the options are said to be “in the money” and can be exercised for a profit. If the market price is lower than the strike price, the options may have little to no value.

Taxation: The holder is generally only taxed once the options are exercised and the shares are sold. The gain from the sale of the shares is then subject to capital gains tax.

Risk: Share options can be riskier than stock bonuses, as their value depends on the shares’ market price. If the market price of the shares decreases, the options may become worthless.

Stock bonuses

Definition: Provide the holder with actual ownership of shares in the company, usually without any additional cost to the holder.

Timing: Typically granted after specific performance metrics have been met or as a discretionary bonus. Stock bonuses do not have a vesting schedule and are generally immediately vested upon receipt.

Value: Stock bonuses have a fixed value based on the current market price of the shares at the time of the grant.

Taxation: The holder is typically taxed on the fair market value of the shares at the time of grant, and the gain or loss from the sale of the shares is also subject to capital gains tax.

Risk: Stock bonuses have a fixed value based on the current market price of the shares.

How to evaluate share options

If you’re looking to incentivise your team and align their interests with those of the company, share options can be a valuable form of compensation. However, evaluating share options can be complex, and startups should consider several factors before implementing a share option plan.

Here are some key factors to consider when assessing share options, as well as strategies for calculating their value and managing associated risks:

Company stage

The stage of the company can impact the value of share options. Consider the strike price of the options and the potential upside for employees.

Company growth prospects

The growth prospects of the company can impact the value of share options so consider the company’s potential for success and growth.

Cash flow

Think about the impact of share options on the company’s cash flow because they may require the company to issue new shares or repurchase existing shares, which can require cash payments.

Vesting schedule

Assess how the vesting schedule aligns with the company’s goals and objectives and whether it incentivises employees to stay with the company for the long term.

Tax implications

Share options may have tax implications for both the company and the employees, so make sure you consult tax professionals to understand the tax implications of share options and develop a plan for managing taxes associated with equity-based compensation.

Calculating the value of share options

The value of share options can be calculated using various methods, including Black-Scholes, binomial models, or Monte Carlo simulations. These models consider factors such as the strike price, the current stock price, the volatility of the stock price, and the time until the expiration of the options. Consult financial professionals to determine the appropriate valuation method for their share options.

Risks associated with share options

While share options can be a valuable form of compensation, they also have risks.

These risks include:

Dilution of ownership

Share options can result in the dilution of ownership for entrepreneurs and existing shareholders.

Complexity of implementation

Share options can be complex to implement, particularly for early-stage startups with limited resources.

Cash flow issues

If the company does not have sufficient cash flow to cover payments associated with exercising the options, share options can create cash flow issues in the long term.

Limited value for employees

Share options may only provide significant value to employees if the company experiences substantial growth or increases the share price over time.

Potential for disputes

Share options can create conflicts among shareholders.

Who can offer share options?

Share options can be offered by any company, regardless of its size or industry. They are typically offered to employees, executives and board members thought might also be offered to consultants, advisors and other service providers.

Eligibility requirements for employees to receive share options may vary depending on the company and the specific share option plan. In general, employees may be required to meet particular criteria, such as:

Length of employment

Companies may require employees to have been with the company for a certain length of time before they are eligible to receive share options. This helps ensure that employees are committed to the company’s long-term success.

Performance metrics

Companies may require employees to meet specific performance metrics before they are eligible to receive share options. This helps ensure that employees contribute to the company’s growth and success.

Employment status

Share options might be limited to certain types of employees, such as full-time employees or employees in specific roles or departments.

How to maximise share option benefits

Share options can be a valuable form of compensation however, employees must develop strategies and negotiate favourable terms to maximise the benefits of share options. It is useful for employers to understand the benefits to employees and what they might include in their own due diligence and negotiations.

Understand the vesting schedule

Employees should understand the vesting schedule and plan their exercise of options accordingly.

Monitor the stock price

Employees should monitor the stock price and exercise options when the price is favorable as the stock price of the company can impact the value of share options.

Diversify investments

Employees should consider diversifying their investments to manage risk which may include selling some shares or investing in other assets.

Consider tax implications

Employees should consult with tax professionals to understand the tax implications and develop a plan for managing taxes associated with exercising options.

Share options and employee retention

Employee retention is a key concern for many companies, particularly in competitive industries where talented employees are in high demand.

By offering share options as part of their compensation package, companies can incentivise employees to stay with the company for the long term and align their interests with those of the company.

When employees have a financial stake in the company through share options, they may be more likely to remain with the company for the long term. They can also help build a sense of ownership and loyalty to the company and motivate employees to work harder and be more productive.

In addition, share options can also help companies attract top talent. In a competitive job market, share options can be an attractive component of a compensation package and can help differentiate a company from its competitors which can be particularly important for startups and small businesses that may have less competitive salaries/benefits than larger companies.

However, the correlation between share options and employee retention is not guaranteed. Companies must structure their share option plans properly and ensure that they are aligned with the goals and objectives of the company. Share options must also be communicated clearly and transparently to employees so that they understand the potential benefits and risks associated with them.

Share options and company performance

There is often a correlation between share options and company performance. Share options can incentivise employees to work towards the company’s long-term success, aligning their interests with the company’s and encouraging them to take a stake in the business’s success.

When employees have a financial stake in the company through share options, they may be more motivated to work harder and be more productive. This can improve company performance as employees focus on driving growth and profitability as well as helping companies to attract and retain top talent.

However, the correlation between share options and company performance is not guaranteed. Share options must be adequately structured and aligned with the goals and objectives of the company to be effective. Companies must also be transparent in communicating about share options, providing employees with clear and concise information about their options and potential benefits and risks.

Share options and corporate social responsibility (CSR)

Share options can play a role in corporate social responsibility (CSR) efforts by promoting employee engagement and alignment with the company’s values and mission.

Share options themselves can be structured to promote CSR efforts. For example, companies may choose to link share options to specific sustainability goals, such as reducing carbon emissions or increasing diversity and inclusion within the company. This can incentivise employees to work towards these goals and contribute to the company’s broader CSR strategy.

Companies may choose to use share options as a way to give back to the community or support charitable causes. For example, a company may donate some of the proceeds from share options to a local charity or invest in social impact initiatives.

Current trends

Share options are a popular form of equity-based compensation and several recent trends are shaping the way companies offer and manage share options.

Here are some of the most recent trends in share options in the UK:

Increased use of Enterprise Management Incentive (EMI) schemes

EMI schemes are a tax-advantaged share option plan designed to help small and medium-sized enterprises (SMEs) attract and retain key employees. In recent years, there has been an increased use of EMI schemes by UK companies due in part to changes in the tax laws that have made them more attractive.

Focus on gender and diversity

There is an increasing focus on gender and diversity in share option plans in the UK. Companies are encouraged to ensure that their share option plans are inclusive and provide equal opportunities for all employees, regardless of gender or background.

Use of online platforms

There is a growing trend towards using online platforms to manage share option plans. These platforms can help companies streamline the administration of share option plans and give employees real-time access to information about their options.

Increased transparency

There is a growing demand for increased transparency in share option plans, particularly in relation to the valuation of the options and the criteria used to determine eligibility. Companies are being encouraged to provide clear and concise information about their share option plans to employees and other stakeholders.

Emphasis on long-term value

There is a growing emphasis on long-term value in share option plans in the UK. Companies are being encouraged to design their share option plans to incentivise employees to work towards the company’s long-term success rather than focusing solely on short-term gains.

FAQ

Should I give shares or share options?

Deciding whether to give shares or share options can depend on many factors, including the company’s goals, the employees’ needs and each option’s tax and legal implications.

Shares can provide employees with a direct ownership stake in the company, which can be a powerful motivator and can align their interests with those of the company. However, giving shares can also have tax and legal implications, as employees may be required to pay taxes on the value of the shares they receive.

On the other hand, share options can provide employees with the potential to benefit from the company’s growth without the tax and legal implications of giving shares outright. Share options can also be structured to incentivise employees to stay with the company for the long term, as they are subject to a vesting schedule that rewards long-term retention.

Ultimately, whether to give shares or share options depends on the company’s and its employees’ specific goals and needs. It is essential to consult with legal and financial advisors to understand each option’s tax and legal implications and to make an informed decision that is in the company’s and its employees’ best interests.

Who can startups give share options to?

Startups can give share options to various individuals, including employees, advisors, and consultants. The specific eligibility requirements for share options may vary depending on the startup’s needs and goals.

Employees are typically the primary recipients of share options. Startups may offer share options to employees at all levels of the organisation, from entry-level hires to senior executives. The eligibility requirements for share options may be based on factors such as job title, length of employment, and performance.

In addition to employees, startups may also offer share options to advisors and consultants who provide valuable expertise and guidance to the company. Share options can be used to incentivise these individuals to work towards the business’s long-term success.

Startups should consult with legal and financial advisors when issuing share options to ensure they comply with all applicable laws and regulations. Startups should also ensure that their share option plans are structured in a way that aligns with the goals and objectives of the company and provides a clear incentive for recipients to work towards the business’s success.

When should a startup set up a share options scheme?

A startup should consider setting up a share options scheme to incentivise and retain employees while conserving cash. Share options can be valuable for startups looking to attract top talent and align employee interests with the company’s.

A share options scheme can be established at any point in a startup’s lifecycle, but it is typically most effective when implemented early on. This allows the startup to incentivise key employees and advisors from the beginning, helping to drive growth and success.

When setting up a share options scheme, startups must consider their business’s specific goals and needs. This includes determining the eligibility requirements for share options, such as job title, length of employment, and performance. Startups should also consider the vesting schedule for share options, which can be used to incentivise long-term retention and alignment with the company’s goals.

In addition, startups should consult with legal and financial advisors to ensure that their share options scheme complies with all applicable laws and regulations. This includes ensuring that the scheme is appropriately structured and documented and that recipients of share options are aware of the potential benefits and risks associated with them.

What is a share option pool? (And why do I need one?)

A share option pool is a reserve of shares a company sets aside for future share option grants to employees, advisors, or consultants. The share option pool is typically established as a percentage of the company’s overall shares and is used to incentivise and retain key talent while conserving cash.

Startups and other growing companies often establish share option pools to attract and retain top talent. By setting aside a pool of shares for future share option grants, companies can offer employees a financial incentive while conserving cash for other business needs.

Establishing a share option pool also allows companies to be flexible in their share option grants. As the company grows and changes, the share option pool can be adjusted to reflect the company’s evolving needs and priorities. This can help ensure the company’s share option grants align with its goals and objectives.

In addition, having a share option pool in place can help companies move quickly when issuing share options. Rather than seeking board approval for each grant, companies can draw from the share option pool to issue share options more efficiently.

What are the tax implications of share options and option schemes?

Share options and option schemes can have complex tax implications for employers and employees. The tax implications can vary depending on the type of share option or option scheme, the jurisdiction in which the company and employees are located, and other factors.

Here are some general tax implications to keep in mind:

Employer national insurance contributions

• Employers may be required to pay national insurance contributions on the value of the shares at the time they are exercised.

Corporation tax

• Employers may be subject to corporation tax on any increase in the value of the shares. This can vary depending on the jurisdiction and other factors.

Reporting requirements

• Employers may be required to report share option grants and exercises to tax authorities and other regulatory bodies.

It is vital for both employers and employees to consult legal and financial advisors to understand the specific tax implications of share options and option schemes and to ensure that they comply with all applicable tax laws and regulations.

How much does it cost to set up an option scheme?

The cost of setting up an option scheme can vary depending on several factors, including the company’s size, the scheme’s complexity, and the legal and accounting fees associated with establishing the scheme.

Here are some general costs to consider:

Legal fees

• Establishing an option scheme typically involves drafting legal documents, such as a share option plan and award agreements. The cost of legal fees can vary depending on the scheme’s complexity and the rates charged by the legal firm.

Accounting fees

• Option schemes can have complex accounting implications, including the need to value the options and account for any related tax implications. The cost of accounting fees can vary depending on the complexity of the scheme and the rates charged by the accounting firm.

Administration fees

• Option schemes may also involve ongoing administration, such as tracking share option grants and exercises, maintaining records, and communicating with employees. The cost of administration can vary depending on the company’s size and the scheme’s complexity.

What is the function of equity Valuation?

The function of equity valuation is to determine the fair value of a company’s equity, which represents the ownership interest of shareholders in the company. Equity valuation is an important tool for investors, analysts, and companies, as it can help inform investment decisions, mergers and acquisitions, and other strategic decisions.

Several methods can be used to value equity, including:

Discounted cash flow (DCF) analysis

• This method involves estimating the company’s future cash flows and discounting them back to their present value. The resulting current value represents the fair value of the company’s equity.

Comparable company analysis (CCA)

• This method involves comparing the company’s financial metrics to those of similar companies in the same industry. The resulting valuation is based on the multiples of these comparable companies.

Precedent transactions analysis

• This method involves comparing the company’s financial metrics to similar companies engaged in mergers or acquisitions. The resulting valuation is based on the multiples of these precedent transactions.
• Equity valuation is important because it can help investors and analysts determine whether a company is undervalued or overvalued relative to its peers or the broader market. This information can help inform investment decisions and strategic decisions such as mergers and acquisitions.
• For companies themselves, equity valuation can be a valuable tool for assessing their financial performance and identifying areas for improvement. By understanding the fair value of their equity, companies can work towards improving their financial metrics and increasing shareholder value over time.

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