One of the bests ways for resource-constrained startups to attract great employees is to give them equity in the business. This helps to motivate by allowing everyone to participate in the upside if the business is successful. But, founders & owners need to be careful not to give away all of their hard-earned equity.
Share options scheme are a good compromise, allowing employees the right to purchase shares at some point in the future at a set price. They are versatile tools that can be tailored to fit unique circumstances, and often come with tax relief, most relevantly under EMI schemes.
An Enterprise Management Incentive (EMI) Option Scheme can be particularly attractive to startups and high-growth companies because of the substantial tax benefits available for employees.
In summary, the tax advantages available for employees are:
- no tax is payable on the grant of the option
- no tax is payable on the exercise of an EMI option as long as it was granted at market value
- Capital Gains Tax is only payable when the employee disposes of the shares and the proceeds of sale exceed the market value as at the date of grant
- Entrepreneur’s Relief may be available on the sale of shares which can reduce the rate of capital gains tax to 10% if the option was granted at least 12 months before the sale
It may also be possible for the company to take advantage of a corporation tax deduction when options are exercised by an employee.
Who can participate?
Employees and directors can qualify for EMI options if they fall under the ‘eligible employees’ category — meaning they work for the company for at least 25 hours per week or, if less than this, 75% of that employee’s total working hours. This often means that non-executive directors and consultants are not eligible.
Further, employees in receipt of EMI options are not permitted (whether alone or together with their associates) to own or otherwise control more than 30% of the ordinary share capital of the company issuing shares.
Does my company qualify?
Most technology companies in growth phase will meet the qualifying criteria, which is gross assets of less than £30 million and less than 250 employees, as long as they are independent and do not carry out one of the following excluded activities:
- dealing in land;
- banking and insurance;
- property development; and
- legal services.
Employees will be permitted to hold unexercised EMI options over shares worth up to the ‘individual limit’ in force at that time, which currently sits at £250,000. The company will also be subject to a cap in relation to the number of options that can be granted, currently set at £3 million worth of shares.
The only restrictions in relation to the exercise of EMI options are that the option holder must be able to exercise it within 10 years of the date of grant, or if the option holder dies within this period, within 12 months of their death. This means that the employer has a considerable amount of flexibility in relation to whether to include performance or vesting criteria, with many early stage technology companies choosing to keep things simple with an exit only scheme.
Process and Deadlines
In order to avoid any nasty tax surprises at a later date, we would recommend that companies agree a valuation with HMRC. As Stephen Clark has set out in a previous blog on ‘How do I set a share option price’, it is worth noting that HMRC are not constrained by the last price paid by any investor and may agree a valuation for ordinary shares to be held by employees which is below the price paid by investors. If the share value is agreed with HMRC, the company has 60 days within which to grant options from the date that HMRC confirms that value. The company will be free to use its own valuation without HMRC confirmation but this comes with the risk of being challenged later on by HMRC.
Once EMI options have been granted, companies must register online with HMRC (if they haven’t already done so) and complete the HMRC electronic notification process within 92 days of the date of grant.
Failure to notify HMRC within the timescales will result in the options being treated as non-qualifying for tax purposes.
Annual Return and Late Filing penalties
Online returns should be filed annually (no later than 6 July after the end of the relevant tax year) by companies operating an EMI Option Scheme. HMRC requires details of the exercise of any EMI options and also details of any release, lapse, cancellation, rollover or adjustment of the options to be reported in the return.
There are penalties if this is not done properly or at all.
For companies not eligible for EMI options, there are other tax-advantaged schemes to consider.
For more information, please contact Michael Arnott – [email protected] — you can see more at: http://mbmcommercial.co.uk/blogs/investments-and-funds/emi-options-–-the-fundamentals/#sthash.J25ODSMW.dpuf
Michael Arnott is a Partner and Head of the MBM Commercial London Office. He acts for companies and their investors in corporate fund-raisings, mergers and acquisitions, and general corporate work. He is also well known for advising investors on how best to realise non-performing assets, which includes financial restructurings, turnaround finance and formal insolvencies. A number of high-profile boards and individuals have sought his advice in relation to their legal duties as directors, generally and during restructuring and insolvency.
Michael’s clients range from entrepreneurs and growth companies to financial institutions and PLCs.