What Are Employee Options?
When it comes to the world of work, there are a lot of things that can be confusing. One of those things is Employee Equity, most commonly referred to as Employee Options. In this post, we’re going to break down what Employee Options are, how they work, and the benefits they offer. We’ll also talk about some of the risks associated with Employee Options and how you can determine if they’re right for you and your company. So, let’s get started!
What are the benefits of Employee Options?
Young businesses can incentivise employees, improve retention and ensure loyalty by giving employees a direct ownership stake in the success of the company.
Employee options or share options are a form of equity compensation that gives employees an option (but not obligation) to purchase shares in the company at a discounted (known as Exercise) price.
Among many other great examples are Klarna and Revolut, which have turned over 70 and 75 employees into millionaires, respectively.
Most commonly, companies offer their employees share options as part of their benefits package and choose government-approved schemes that also provide tax benefits to employees.
What are the types of Employee Option Schemes?
It’s common for early-stage businesses to allot around 10-20% of the company’s equity to the Employee Share Option Pool.
A company usually offers options to full-time employees through one of the government-approved share schemes (qualified options), which provides tax benefits to employees.
Advisers, contractors and those employees working less than 25 hours per week are usually offered unapproved options (also known as non-qualified stock options – NSO).
Employee Stock Option Plans is a term most commonly used in the United States or Employee Share Schemes term used in the United Kingdom to describe the government-approved or qualified plan which allows employees to exercise (purchase) shares with tax benefits. From a tax authorities perspective, the difference between the fair market value of shares at the time of exercise and the exercise (purchase) price is considered income.
Income made from exercising qualified share options is taxed at the capital gains tax rate (typically 15%) in the US, which is lower than ordinary income tax. Qualified share options are not subject to income tax at all, for example, in the UK. In all jurisdictions, income from non-qualified stock options is considered ordinary income and is therefore not eligible for the tax break.
There are several different types of Approved Share Schemes in the UK:
- Enterprise Management Incentives (EMIs) – the most popular among startups
- Save As You Earn (SAYE)
- Company Share Option Plans
- Share Incentive Plans
There are also different types of Qualified Stock Option Plans in the US:
- Incentive stock option (ISO) – the most popular among startups
- Restricted Stock Units (RSU)
- Employee Stock Purchase Program (ESPP)
- Employee Stock Ownership Plan (ESOP)
Employee equity also can be issued as restricted stock (also known as deferred shares) with the reverse vesting schedule. In this scenario, a company actually issue shares now, but such shares have restrictions and can be cancelled if an employee leaves the company sooner than is agreed in the agreement.
The UK Enterprise Management Incentives (EMIs)
Enterprise Management Incentives, or EMIs, are a type of Share Scheme specifically designed for small or medium-sized companies in the UK. Through an EMI scheme, eligible employees can receive share options with special tax advantages, including not paying Income Tax or National Insurance on the value of the shares at the time they are granted or when they are sold.
If you are a small company, you may be able to offer your employees Enterprise Management Incentives (EMIs).
Advantages
If your company is worth £30 million or less, it may qualify for Enterprise Management Incentives (EMIs), which would allow you to grant share options up to a value of £250,000 over 3 years per employee. If your employee buy the shares at or above the market value they had when the option was granted, then they won’t have to pay Income Tax or National Insurance on them. This means that if the company’s shares increase in value, your employees have the potential to make some major profits on those shares.
The exercise of options granted under an EMI plan will result in a Corporation Tax deduction for the company as long as certain criteria are met.
The relief is granted for the accounting period in which the employee stock option is exercised. The amount of relief is equal to the difference between the market value of the option shares on the date of exercise and the exercise price.
Employees won’t be charged income taxes if they exercise the EMI option as long as it was granted at market value, exercised within 10 years of the grant, and no ‘disqualifying event’ has occurred.
Disadvantages
If the market value of your shares was discounted (lower than the fair market value), you’ll have to pay Income Tax or National Insurance on the difference between what you paid and what the shares were worth (fair market value). If you sell the shares, you may also be required to pay Capital Gains Tax.
Companies that engage in the following activities are not allowed to offer EMIs: banking, farming, property development, provision of legal services, and shipbuilding.
There are a few notable exceptions, but the general rule is that only full-time employees (those who work more than 25 hours per week) can receive EMI options. The options document must include a statement from the employee acknowledging that they are a full-time employee.
If any of the following occurs, the company may lose its tax-advantaged status:
- The company does not set up its EMI according to the legislation.
- The company fails to notify HMRC of an option grant within 92 days.
- A disqualifying event takes place, and option holders don’t exercise their options within 90 days.
It is feasible to work out a company’s worth for EMI purposes with the HMRC. This can be completed by submitting form VAL231 to the Share and Assets Valuation (SAV) department at HM Revenue & Customs. The valuations are only valid for the next 90 days, so make sure to take advantage of the EMI option grants within this timeline.
However, according to HMRC, owing to COVID-19, there may be a delay in issuing EMI options that lasts more than 90 days. They’ve stated that any new EMI valuation agreement letter issued between 1 March 2020 and 1 December 2022 will be valid for 120 days from the date of issue.
Upon submitting form VAL231, HM Revenue & Customs will agree to two valuations. The first valuation is what’s called the Unrestricted Market Value (UMV). To calculate UMV, take the value of all equity in the company and divide it by the number of outstanding shares. The second valuation is lower, and it’s the Actual Market Value (AMV), which takes into account minority discounts as well as the discount to reflect the restrictions on the options themselves (such as the potential loss of options if certain events take place like quitting your job). The exercise price cannot be less than the AMV.
The US Incentive stock option (ISO)
For early-stage companies starting in or expanding into the US, it’s the most common to up an ISO from the outset. This option is more favourable to employees if held and exercised within specific time frames. The benefits of an ISO outweigh the slightly higher setup costs.
This option allows you to grant stock options to your employees at a discounted price, provided they stay with your company for a certain length of time. If they leave before the end of this period, they forfeit their rights to exercise their options.
The benefit of an ISO is that it gives your employees more flexibility if they want to leave after a period of time has elapsed. For example, if an employee leaves after three years but before six years have passed (the usual period), then they will still be able to exercise their options at a discounted rate—as long as it’s within three months of leaving. A new 2018 tax code Section 83(i) allows employees (except most senior) to exercise and defer tax for up to five years or until shares become tradeable. When you sell the stock after exercising your options, there are different tax consequences depending on how long you’ve held it:
If you sell it more than one year after exercising and two years after being granted (these are called “holding requirements”), then any gains on the sale are taxed as long-term capital gain, which has a lower rate than ordinary income (0–20% depending on the size of gain).
If you don’t meet those holding requirements, then the sale is treated as ordinary income and subject to higher rates than long-term capital gain (15% for most people).
Incentive stock options (ISOs) are a type of employee stock option that can be issued to employees of the company or any parent or subsidiary of the company. ISOs have some limitations:
- They must be issued to employees only
- The combined fair market value of stock that becomes exercisable in a calendar year must not exceed $100,000
- They must have a maximum term of 10 years
- The recipient must exercise them within three months of leaving the company
Are ISOs subject to 409A?
Section 409A of the United States Internal Revenue Code governs nonqualified deferred compensation plans (e.g., stock options). Section 409A requires private companies to obtain a third-party appraisal of the company’s valuation and value of its share classes (known as “409a valuation”). This third-party assessment is based on the fair market value (FMV).
Although ISOs are not technically subject to Section 409A (because, by definition, the exercise price of an ISO is at least equal to FMV at the time of grant), companies are recommended to consider obtaining Section 409A valuations even when granting ISOs.
The primary reason for this is that such valuations can provide assurance and are frequently 60% below the last round valuation. This variation depends on the preference structure and closeness to exit.
Are there any risks associated with Employee Options?
There are also potential risks associated with Employee Options, like if the market value of company shares decreases or if employees have to pay Income Tax exercising shares. It’s important to consider all factors and do careful research before making any decisions about granting Employee Options and making them as tax-friendly for employees as possible.
The shares offered outside of the approved schemes (qualified plans) will not have the same tax advantages.
When employees leave a company, they get a time period called the “exercise window”, the amount of time an employee has to exercise their vested options after leaving the company. Usually, this period is only three months, so employees are forced to purchase shares very quickly, much before any liquidity event, in order not to lose the tax advantage.
This could be a great disadvantage and burden for an employee. On the other hand, it could also be a pitfall for employees if they are ready to buy shares, but a company now wants to activate its buyback rights. Buyback rights probably should not be a part of the Option Agreement.
Another important risk to mention, options are a popular employee benefit and can be a great way for employees to invest in their company’s future. However, investing in stocks can be risky, so make sure your employees fully understand the risks before making any decisions about purchasing/exercising shares through Employee Options.
How do I know if Employee Options are right for my company?
Employee Options are a great way to attract and retain the best talent. They’re also a great way to motivate employees and align their interests with your company’s.
Most commonly, growing companies need to attract and retain talent to maintain growth. Once the company attracted funding and is capable of paying salaries, they also required by an institutional investor to set up an employee equity pool.
Employee Options are becoming more and more popular with companies these days. They’re not as straightforward as a paycheck, but they have the potential to generate a pretty large profit.
If you want to learn how to set up an employee share option plan, book a free consultation with our team.
Photo Credit to Austin Distel
