Sharing incentives: fostering alignment and engagement

Posted: 21/01/2025

Incentivising employees

Funding has been raised, and the company is now in a position to take on employees. However, the cash has been raised for research and development and it is difficult to complete with large companies for employees when it is not possible to offer the same salaries.

The first step should be to consider whether some form of participation in the growth of the company can be offered, so that employees can buy into the journey. Share incentives can be a tax efficient and low-cost (at least in cash terms!) way to attract the best employees.

There are many different kinds of share incentives, but an Enterprise Management Incentive (EMI) scheme which provides options to acquire shares in the future is the gold standard and is designed for small and medium sized high growth companies.

EMI tax advantages

• There is no tax when the option is granted.
• If the exercise price is set at (or above) the market value of the shares at the time of grant, there would be no tax to pay on the exercise of the option.
• The growth in value of the shares will be subject to capital gains tax (CGT), but only when the shares are sold.
• The CGT rate can be as low as 10% on the first £1 million of gains.

If the exercise price is set at a discount to the market value on grant, tax would arise when the option is exercised, but only on the discounted element – the growth in value from grant is still taxed to CGT only when the shares are sold.

If the option is granted at least two years prior to the shares being sold and provided that the individual is still a director or employee when the shares are sold, the first £1 million of gain will be taxed at a 10% rate.

Qualifying company

A company can only grant EMI options whilst it is a qualifying company.

The company must be independent, which basically means another company must not own more than 50% of its shares, so an EMI scheme can only be set up in the parent company if it has a group of companies. Check the shareholding of large corporate investors, which may exceed 50% in the early stages for a start-up.

The company must carry on a qualifying trade – there are certain activities which, if carried out by a company to a substantial amount, will prevent the company from being a qualifying company.

The gross assets of the company (or group) must not exceed £30 million. The company (or group) must have fewer than 250 employees. These two tests only need to be met when the option is granted, so if these figures are exceeded after an option is granted, it will not prevent it from qualifying under the EMI scheme (but no grants can be made under EMI whilst the limits have been exceeded).

EMI eligible employees

In order for an employee to be eligible for an EMI option, they must work for the company or another group company. The employee must work for that company for at least 25 hours a week or if less, 75% of their working time. So a part-time employee who only works for the company will qualify if they do not have another job, but if they work three days for the company and two days elsewhere, they will not. The employee must not have a material interest in the company (a shareholding of 30% or more), so some founders may not qualify for EMI options.

Scheme limits

There are certain limits on the value of EMI options which can be granted to any one employee and by the company as a whole.

For an individual employee the total amount of unexercised options must not exceed £250,000. This limit is based on the value at the time the option is granted; there is no limit on the value of the shares at the time of an exit.

The total value of unexercised EMI options in the company (or group of companies) must not exceed £3 million (again, based on the value at the time of grant).

It is possible to agree a valuation with HMRC in advance of granting the option, which will allow the company to keep track of these limits. Generally, HMRC will agree a valuation that is discounted from the funding round price.

Option terms

The EMI option scheme is really flexible, and any conditions can be set for the options, provided that (i) they are capable of being met within a 10 year period and (ii) they are set out in writing in the option agreement.

The two main considerations for designing an EMI scheme will be (i) what conditions should attach to the option and (ii) what should happen when someone leaves.

Time and performance based vesting

In relation to the conditions, the best question to ask is ‘what does the employee need to do in order to earn their options?’ This could be based purely on the time they work for the company. It is fairly standard for time-based vesting of an option to be spread across three or four years. This can be set in any way, but to give some examples, it could be in equal annual tranches or using a ‘cliff’ vest after 12 months followed by monthly or quarterly vesting.

It is also possible to set performance conditions. This could be based on company performance or individual performance. The conditions may be different for different individuals. When setting performance conditions, the most important point to consider is whether the individual being granted the option has any control over the achievement of the condition being set. If they are not able to do anything to achieve the condition, this may have a disincentive effect.

Once an option has ‘vested’, it will be important to consider when the individual can buy the shares. That could be any time from when they are vested, only on an exit or some other trigger event. Even where options are capable of exercise once vested, it is more common for an option holder to wait for an exit before exercising the option.

Leavers

Considering the position if someone leaves the company will be necessary. Some option agreements provide that all options lapse if someone leaves the company, regardless of the reason. A more common position is to draw a distinction between a ‘good leaver’ and a ‘bad leaver’, with a ‘bad leaver’ losing all options and a ‘good leaver’ being entitled to retain and exercise the vested part of an option. It is possible to delay exercise for a good leaver until exit, but if the option is not exercised within 90 days of cessation of employment (one year on death), the tax treatment of the option will change from cessation of employment and further growth in value will be subject to income tax and possibly National Insurance contributions when the option is exercised.

This article is an edited summary from Penningtons Manches Cooper’s guide on ‘Navigating the journey of growth: key legal considerations for scaling up’. For a copy of our guide, please click the banner below or get in touch with your usual contact.

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