Employee share incentives are becoming increasingly important in the tech sector, as they can be used both as a hiring tool and as a cost-effective way to retain and motivate employees. In fact, many employees in the tech sector now expect equity to form a part of their reward package.
Structuring the incentive
For a large number of early stage tech companies, share options can deliver the desired motivational impact whilst minimising the administrative and costs implications of the incentive. Share options give the employee a contractual right to acquire shares at a fixed price and on a future date (or dates). In the UK, that future date is typically on the occurrence of a liquidity event such as a share sale or IPO (as opposed to the typical US model which provides for vesting over a four year period, with a one year cliff).
The grant of share options has a number of advantages over awarding shares directly to employees at the outset of the employment relationship, including the following:
- there is no upfront funding obligation and no income tax or National Insurance Contributions (NICs) to pay on the grant of a share option;
- share options are a risk-free investment for employees - there is no obligation for the employee to exercise the option and purchase the shares;
- granting options can avoid the administrative, tax and cost implications involved with employees becoming minority shareholders;
- if granted as an enterprise management incentive (EMI) option, there is no tax benefit for the employee to exercise the option before any share sale or IPO;
- if the company expands internationally it is relatively easy to replicate the same option arrangements across other jurisdictions and the concept of "options" is a well know currency across employees in the tech sector internationally; and
- the aggregate option gains for all employees on exercise on a share sale should attract corporation tax relief and can therefore prove a useful asset when it comes to valuing the company.
An incentive which can minimise tax leakage is particularly motivational and early stage tech companies with UK based employees often have an advantage over more mature companies, as they typically qualify to grant EMI options. This highly tax-advantaged form of share option results in the growth in value of the shares in the period from grant to exercise being taxed as capital, not income. The tax efficiencies affect not only the employee but also the employing company, which can benefit from employer NICs savings that are not available for cash reward packages.
When implementing share option arrangements, there are three fundamental factors that a company needs to consider:
- the size of the option pool and individual awards;
- when the options should deliver reward; and
- what should happen to the options if an employee leaves.
The size of the pool and awards
Giving away too much equity too soon can lead to unnecessary dilution and make it more difficult for the company to attract external financing. It is best practice to agree with investors, as part of any fundraising, a maximum percentage of the fully diluted share capital which can be used to incentivise employees. There is no hard and fast rule, and the size of the pool will take into account factors such as the number of employees, their level of seniority, the likelihood of future hires and the growth forecasts. It is not uncommon for up to 10 -15% of the fully diluted share capital of the company to be allocated to the initial share option pool.
Consider how the option pool should be allocated between employees. We would typically expect the initial strategic hires to be awarded a greater percentage of the overall pool than later hires, to reflect not only their impact on the success and growth of the business, but also the risk of joining the company at an early stage.
The company will need to consider whether to offer the same or significantly different packages for hires in comparable positions. Relevant factors will include what base salary the hire has negotiated, how difficult it is to recruit for their role and whether they have forfeited equity in a previous employer in order to take on the role.
The tax effectiveness of tax advantaged share options is driven by the value of the company (so the lower the value of the equity, the greater the ultimate reward for the employee). To avoid over-compensating an employee who doesn't perform as planned, it might be prudent to grant options while the share value is low, but provide for those options to lapse if certain individual or company based performance criteria are not satisfied.
A key consideration in the design of share options is when the options should become exercisable.
There is no need for the shares acquired on exercise of an EMI option to be held for a significant period of time before sale in order for capital treatment to be obtained on exercise. It is therefore common for early stage tech companies to establish EMI share option arrangements that deliver reward only on the occurrence of an exit event such as a share sale or listing.
This approach minimises the administration involved with the share option arrangements, which is a significant benefit for early stage companies with limited manpower. It also helps to align the interests of the option holders with those of the founders and investors, as they all benefit from the success of the business at the same time.
The treatment of share options on termination of employment can be a sticking point and can lead to protracted negotiations on termination if not addressed at the outset.
It is often the case that investors in early stage companies will require the founders to agree to a fairly detailed set of leaver provisions in relation to their equity. However, there is no need, and often it is not appropriate, for those provisions to be mirrored for employee share options.
Where share options are viewed as an incentive to deliver an exit, as is often the case for early stage tech companies, it is increasingly common for a straightforward "leave and lose" approach to be adopted. These ensure that the options deliver reward only to employees who remain committed to the company up to the exit. This type of leaver provision is often accompanied by a board discretion (typically exercisable only with investor consent) to treat an option holder more favourably in exceptional circumstances.
How can Osborne Clarke help?
At Osborne Clarke we have a dedicated team of incentives lawyers who have a wealth of experience in the design and implementation of share incentives for start-up and early stage tech companies, both in the UK and internationally. For more information, please contact your usual Osborne Clarke contact or one of the experts listed below.