An introduction to share option schemes for startups

There are various things to think about before deciding on the structure of a scheme. In particular:

What are the risks of employees holding shares or voting rights?

Giving employees an eventual ownership of the company can have consequences. Steps may need to be taken to ensure that the employee shareholders do not become a ‘swing vote’ between two or more groups of shareholders. This can easily be dealt with by requiring the employee to sign a shareholders’ agreement (but if the options are ‘exit only’ this may not be necessary).

In addition, it is possible to grant EMI options or to allot shares which do not carry voting rights but only have rights to capital proceeds and dividends (i.e. the shares have economic rights but not ‘control’ rights). 

Steps should also be taken to ensure that if an employee has shares, they are required to sell them back if they leave employment.

Given that a sale of a company would usually require 100% participation, it is also strongly advised to put in place ‘drag’ rights to ensure that the company can be sold whether or not a minority shareholder wishes to proceed. 

If options are issued, when can they be exercised? 

You will also need to consider when employees will be able to exercise their options. Some options state that the employee, provided they remain employed for a period of, say, two years, will be entitled to exercise the options by paying the exercise price. This is known as ‘vesting’.

Many companies opt to issue so-called ‘exit only’ options. These are options which only become exercisable if the company is sold, listed or wound up. The idea behind these options is usually to incentivise employees before a proposed sale of the business in the medium term. The advantages of exit-only options are that they can focus employees’ attention on an eventual exit and in addition there is no risk of the employees becoming shareholders until the business is sold (in practice the employees would usually never actually be shareholders as they sell their shares as soon as they exercise the option).

A typical approach taken by start-ups is for a combination of vesting and exit-only options. The vesting provisions are often ‘four year vesting with a one year cliff’, which means that if an employee leaves in the first year, they lose all of their options (this is the ‘cliff’). However, if they stay at the business, 25% of their options vest on each of their first, second, third and fourth anniversaries. Despite having vested, they may still only be exercisable on exit, i.e. ‘exit-only’. The final piece of jargon is that these might ‘accelerate’ on exit. This would mean that if an exit happens before the options are fully vested, they all automatically vest immediately prior to the exit. 

For most trading companies, the Enterprise Management Incentive (EMI) scheme is available and offers substantial benefits.

What are the main benefits?

Provided that the company and the employee qualify for the scheme, then options can be issued to the employee and no income tax, employee, or employers’ national insurance contributions will arise either on granting the option or once the option is exercised and the employee buys their shares.
 
If an ‘unapproved’ option (i.e. an option which is not within an HMRC scheme) is awarded, then income tax may still be payable once the option is exercised. 

There is an additional benefit where shares are awarded through the EMI scheme. When the employee sells the shares, the employee should be able to benefit from Business Asset Disposal Relief (giving them an eventual effective capital gains tax rate of just 18% (from 6 April 2026) on the first £1m of lifetime proceeds) even if:

a) they own less than 5% of the company’s shares (generally an employee needs 5% or more to qualify for the relief); and

b) they have not owned the shares for two years (provided the shares are sold at least two years after the date of grant of the option)

With many option schemes, the company itself can also obtain a corporation tax deduction on the market value of the options on exercise, subject to the usual employee related securities rules. This can be a significant benefit.

There may be tax to pay on exercise if the exercise price of the option is less than the market value of the shares at the time the option is granted. The valuation can, however, be agreed with HMRC before the options are issued. 

In nearly all cases, if the qualification criteria are met, it is worthwhile issuing EMI options rather than unapproved options.

Provided the company qualifies, it can grant EMI options up to a total value of £6,000,000. Each employee can hold options with a value of up to £250,000.  

In order to qualify, the company must be an independent company trading with a ‘permanent establishment’ in the United Kingdom, and with gross assets (i.e. the total value of assets, ignoring liabilities) of less than £120,000,000 and less than 500 employees. The company’s trading activities must not include certain excluded activities such as land dealing, farming, legal and accountancy, banking etc.

There is no procedure for approval of the scheme itself but there is procedure for approving the market value of the option at grant (which is usually the ‘strike price’ or ‘exercise price’ at which employees buy the shares). There are also criteria in relation to the types of employee who can benefit from an EMI option.  

Employee eligibility

The staff benefiting from the options must be employees (not contractors) and must work at least 25 hours a week for the company (or, if less, must spend at least 75% of their working time working for the company).  The employee must own less than 30% of the share capital of the company when the option is granted.

Valuation

Before the share options are issued to the employees, the value of the shares (that is the exercise price at which employees will be entitled to purchase shares if the option vests or becomes exercisable) may be agreed in advance with HMRC.

The risk of not obtaining a valuation is that HMRC may argue later that the exercise price is less than market value at the time the option is granted. Once HMRC has confirmed the share price, the valuation will be valid for 90 days.

It is not compulsory to agree the value with HMRC beforehand but it is strongly recommended, otherwise HMRC may argue later that the true market value of the company was higher than the exercise price at the time of grant of the options, giving rise to a potential income tax charge.

Disqualifying events 

Certain disqualifying events can remove the EMI scheme tax benefits but the scheme can be drafted in such a way that the option will continue with a different taxation status even if a disqualifying event occurs.  
If you have non-UK tax resident employees or contractors who wish to benefit from the share scheme, then you can put rules in place allowing for options to be issued under the same scheme even if they will not qualify for EMI benefits.  

Can non-employees benefit?

While the EMI scheme offers a good solution for employees who meet the criteria, it is not applicable to non-employees (e.g. a non-executive director or contractors). As they will not qualify for EMI tax treatment, the value of the option may be treated by HMRC as income arising from their role as contractor or director.

In this case, it is worth considering other ways to incentivise staff, and often restricted shares or growth shares are appropriate instead. 

Companies considering an employee equity incentive should begin by assessing whether they are eligible to operate an EMI scheme and whether EMI is the most appropriate structure for their commercial objectives. Businesses will typically want to:

1. confirm whether the company meets the EMI eligibility criteria (including size, trading activities and independence)consider which employees should participate and the level of equity to be offered
2. agree an appropriate structure for the options, including vesting, leaver provisions and exit mechanics
3. obtain a valuation of the shares and, where appropriate, agree that valuation with HMRC in advance; and
4. ensure that the scheme documentation aligns with the company’s articles, shareholders’ agreement and future funding or exit plans

Early advice is recommended, particularly where the company is approaching the EMI thresholds, planning a fundraising or exit, or considering alternatives such as growth shares for non employees.
 
Proper planning at the outset can help ensure the scheme delivers the intended incentives while preserving the available tax advantages.

Sally Johnston and Guy Wilmot are both partners in the corporate and commercial team with particular experience advising startup and scaling companies on all aspects of corporate and commercial law.