Alicia Walker
Alicia has been writing, editing, and creating content for leading publications and digital businesses across all corners of the globe for more than a decade.
Table of Contents
Allocating shares to a startup team
Early-stage founders and first hires often cite excitement as the key reason for joining a startup.
Working for a startup typically means personal sacrifice and losing the security of a higher-paying role with established companies.
The dilemma of the founder or early founding team is how to incentivise additional core founders and build a highly skilled team by sharing this potential growth.
With shares, you must start at the beginning
For a new company with only one shareholder, the simplest way to reward successful new hires is to give them shares. It is a straightforward process and involves minimal paperwork to update the company register and shareholders agreement.
The benefits of your team becoming shareholders in the company are often psychologically important. Shares unite the team as ‘founders’, which helps foster an owner mentality, creating goodwill that fuels the startup vision.
The drawback of this approach is that, while the team is anchored by share ownership, any team members leave to do so with their shares.
Nothing ties share ownership to their employment contract with the company, and this risk level is naturally inappropriate for every worker.
Protect your shares using forward vesting
To countenance the risk of staff leaving with shares, it is common for early-stage companies to vest shares.
Vest means awarding a specific number of shares to an employee over a specified period.
Example of forward vesting
Rather than awarding 1% of the company’s shares today all in one go, Sarah is asked to work for the company for one year, following which half her shares will be awarded. The other 50% are given over the next two years.
Share vesting has the obvious benefit that if Sarah leaves within a year for any reason (from performance issues to simply not wanting to work at the startup anymore), she does so without any shares. If she leaves after 12 months, she does so with half her shares.
Awarding shares like this are often referred to as restricted shares. Sarah does not own the 1% outright, and she will need to work for the company for at least three years to own them all.
Companies typically set out the restrictions in a share vesting agreement, which may be quite detailed but typically govern how the employee earns the restricted shares, for example, by hitting certain work-related milestones, time with the company, and seniority. There are also restrictions on what happens to the employee’s shares if they leave the company earlier than planned.
The company ordinarily will want to avoid employees leaving early with shares or, worse, taking them after a bad performance. So, a “good and bad leaver” provision in share vesting agreements is common. These provisions handle situations in which employees are let go for poor performance or resign early, with differing economic outcomes for the employee.
When an employee receives shares, the shares will ordinarily be treated as income and taxed in the UK.
In addition, there is usually a tax event when the shares are actually sold, and the tax paid at that time is capital gains tax (CGT). These taxable events can surprise early-stage entrepreneurs who find that a significant portion of their expected windfall is taxed. This is especially so in startup companies that grow incredibly quickly and increase share value exponentially.
Reverse vesting of shares for tax purposes
After vesting, there is usually a tax event when the shares are actually sold, and the tax paid at that time is capital gains tax (CGT). These taxable events can surprise early-stage entrepreneurs who find that a significant portion of their expected windfall is taxed. This is especially so in startup companies that grow incredibly quickly and the share value increases exponentially.
To address this situation, startups can use reverse-share vesting. Although complex sounding, this can be quite simply understood using the same example as above.
Example of reverse vesting of shares for tax purposes
Sarah is awarded 1% of the shares in the company, and again, she will receive half after 12 months, with the remainder over the next two years. However, with reverse vesting, Sarah gets the complete 1% of her shares on day one.
The company then has a right to take back her shares (often described as a clawback), which begins with a right to take all the shares back, reduced to a right to take back only 50% of the shares after 12 months, and then to zero after the full vesting period.
In this way, the same mathematical position is achieved insofar as Sarah receives 1% of shares in the company over three years, only this time, she receives them all at the start.
Why use reverse vesting?
The idea behind this structure is that the startup’s shares should be at their lowest value in its earliest years. Hence, if an employee receives shares in a drip feed over a more extensive timeframe, the potential for income tax increases dramatically as the value of the shares awarded does each year.
By making the legal transfer on day one at the company, the employee benefits from the award with a low value and could benefit from the lower tax.
Navigating the tax implications of vesting shares
To benefit from reverse vesting, you will need to arrange for your startup and the employees to enter into what’s known as a section 431 election, which is filed with HMRC.
The effect of this election is that no tax is paid by the employee on the date the shares are awarded. It can reduce the tax payable to only capital gains tax (CGT) (at the Entrepreneur Relief level of 10%, payable on the gain in value when the shares are sold). This election must occur within 14 days of the share vesting agreement being signed.
It is worth noting that from a tax perspective, for pre-seed or pre-revenue startups (if not fundraising), giving shares to the team at a nominal value does not create any of the above tax implications since the shares have no value at that time.
What is the difference between shares and share options?
When you give your employees shares, they immediately become shareholders. They now wear two hats: As an employee and a shareholder with all the rights that come with being a company shareholder, for example, rights to a dividend, voting rights, and the growth in financial value.
A share option (generally referred to as an option) is different and is the right to buy shares in the future. Giving your employees options means they could be shareholders at some future time, but for that to happen, they would need to convert their options into shares.
Converting options into shares is known as ‘exercising’ the option. This mechanism allows an employee to acquire shares at some point in the future by ‘exercising’ the option at a price set at the award date.
The ability to exercise the option is set out in their option agreement. It is likely contingent on the employee hitting certain employment milestones or the company achieving a landmark event such as significant fundraising, a trade sale, or an IPO.
Share schemes can be split into those that have received HMRC approval and benefit from favourable tax treatment and unapproved schemes (which, as the name suggests, HMRC has not been notified of). The tax position (which primarily impacts the employee) when they exercise their options varies depending on which scheme is adopted. We will focus on the difference between the tax-advantaged EMI Scheme and unapproved schemes.
Enterprise Management Incentives (EMI Scheme):
EMIs are tax-advantaged share options. Under the share option plan, employees are allowed to acquire company shares within a specified period and at a fixed price, set up to minimise employee tax. There are strict criteria for setting up an EMI Scheme, but most early-stage startups can satisfy these:
Qualifying companies
EMI is available to companies with gross assets of £30m or less. In a group, the gross assets test is applied to the group.
The company must carry on a qualifying trade; most tech companies usually qualify. Trades that do not qualify include leasing, farming, financial activities, and property development.
If you have a group setup (with a Holdco), EMI share options must be granted over shares in the parent company (the Holdco), and at least one of your subsidiaries must carry on the qualifying trade.
Your startup must not be under the control of another company. (However, the parent company of a qualifying group can grant EMI options to group employees.)
Qualifying options
Options must be granted to employees or directors over fully paid shares that are not redeemable. The shares can be subject to restrictions.
- Only EMI options on up to £250,000 worth of shares per employee qualify for EMI.
- Options can be granted at a discount or nil price, which usually negates the tax advantages.
- Options must be capable of being exercised within ten years.
Eligible employees
EMI options can only be granted to employees who are required to work at least 25 hours a week, or, if less, at least 75% of their working time must be for the company.
Employees with a ‘material interest’ of more than 30% of the share capital before the options cannot be a part of the scheme.
Tax considerations
The company pays no tax on EMI options. Because options are not considered ‘readily convertible assets’, they will not ordinarily be regarded as earnings for NICs (so no charge to the company or employee).
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Valuing your startup to reduce your team’s potential tax liability
Agreeing on the company’s value with HMRC (the taxman) when the EMI options are granted gives certainty that no income tax charge will arise.
If the options are granted under an EMI scheme, and the exercise price is at least equal to the market value of the shares when the options are granted, then no income tax will be payable on either the grant of the options or on the exercise of the options.
If the options are granted at an exercise price below the current market value of the shares, there will be no income tax on the grant of the options, but employees will pay income tax on the exercise of the options.
Income tax will be charged on the lower market value of the option shares at the date of grant or the date of exercise, less the total price actually paid for the shares.
Entrepreneurs Relief at the sale of shares
The second key advantage of EMI shares is that if the employee has held the shares for 12 months or more, any capital gain made on the sale will be taxable at 10% (a reduced rate for entrepreneurs) rather than at 28%.
As with share vesting arrangements, there is a large degree of flexibility regarding the conditions of the option award, including when the employee may exercise the option and acquire the shares, but these must be specified in the option agreement.
They can vest immediately or after a certain period, perhaps after certain performance conditions are met. A common and popular condition is that options only vest immediately before a trade sale, IPO, or major fundraising event.
Example of relief at the sale of shares
Noah is granted 10,000 options at an exercise price of £5 per option. After two years, Noah exercises his options and pays the company £50,000 (10,000*£5). The actual market value of the shares in the company is now £20, so Noah now owns a value of £200,000 shares (10,000*£20). The £150,000 increase is not liable to tax or NICs because the options are granted through an EMI scheme.
If Noah sells his shares now for £200,000, he will pay CGT at the reduced 10% on the capital gain because he qualifies for Entrepreneur Relief.
Unapproved employee share option schemes:
An unapproved option scheme involves granting share options without HMRC approval. It can be used in any situation where the criteria for the EMI scheme cannot be met.
Ordinarily, in the context of a startup, this is likely because either the plan requires much more flexibility than the EMI scheme permits, the number of options is above the EMI threshold, or the individuals being issued options can’t satisfy the criteria for ‘employee’ under that scheme, either because they are not working sufficient hours or are not employees.
So, this scheme can, of course, still be of tremendous value to incentivise consultants, advisors, or individuals outside of UK tax.
Income tax in unapproved share options
Usually, no income tax is due when the option is granted under an unapproved share option scheme. However, there will always be a charge when the options are exercised. Naturally, for UK taxpayers, this is less appealing than using an EMI scheme.
On the exercise of an unapproved option, the employee will face an income tax charge based on the market value of the shares at the time of exercise, less any amount paid for the options and on exercise (if anything).
In contrast with an approved scheme, the tax charge arises in the year of exercise of an option and not on the subsequent disposal of the shares, meaning the employee may need more funds to pay the income tax liability.
An employee will usually be subject to capital gains tax at their applicable rate of up to 28% on the disposal of the shares. The amount of the chargeable gain is the difference between the disposal proceeds and the price paid.
Example of unapproved share options
Noah is granted 10,000 options at an exercise price of £5 per option. After two years, Noah exercises his options and pays the company £50,000 (10,000*£5). The actual market value of the shares in the company is now £20, so Noah now owns a value of £200,000 shares (10,000*£20). The £150,000 increase is liable to tax and NICs because the options are granted through an unapproved scheme.
If Noah sells his shares now for £200,000, he will pay CGT on the gain at a rate up to 28%.
