Lifecycle of a tech startup series: Incentivising Employees

Episode 12

22 July 2022

KNow Wear Ltd is now starting to flourish. The sample products manufactured in Burnley have tested above expectations and the company is looking to take on new staff to build out the sales and development teams. It has a difficult task now however – how does it hire the best staff, when it can’t offer the best salaries?

This is a common problem for start-ups. KNow Wear Ltd might not become the next tech unicorn, but it is going to dramatically improve its chances if it can hire the best people to build and promote it. The company is not able to compete with the salaries established larger competitors offer or offer such a robust benefits package and it doesn’t have the luxury offices someone like Google would. Instead, it needs to play to the one advantage it has.

That strength is in its potential. Google (or Alphabet) is already huge, at the time of writing its market capitalisation is almost $1.5 trillion. It is unlikely to increase 100x in value over the next couple of years. KNow Wear Ltd could however, and it can entice ambitious employees by offering them a share of that potential growth.

What is a share option?

Put simply, it is a right to acquire shares in a company in the future. It might be subject to performance conditions (which might be personal – hitting an individual sales target for example, or companywide – hitting an EBITDA figure for example) or it might be subject to vesting conditions (for example, 20% of the option might vest each year for five years). These are the finer details. The bigger picture is potential employees can be sold on the possibility that, in five years, their options might be worth enough for them to retire in luxury (or buy a house etc), and their own hard work can help make that a reality. The value of share options is uncapped and, the harder the employee works and the more he or she helps grow the company, the more reward they will get on an exit event such as a sale. A share option aligns employee interests with founder interests. It can also be drafted to fall away should an employee leave, incentivising them to stay with the company.

 

What is an EMI share option?

The receipt of a share option, if properly explained to employees, is a hugely powerful recruitment and retention tool. In the author’s view it is the single most powerful tool a smaller company has at its disposal to attract staff. Making that share option a tax approved “EMI” option greatly enhances the financial benefits, massively increasing the net sum an employee takes home. This is explained most clearly with an example:

Example

KNow Wear Ltd wants to hire a head and deputy head of sales. It is in touch with Aggie, a proven high-flyer in selling wearable tech. Aggie is working for a large company. It is also in touch with Edith, an ambitious recent graduate who has great potential.

Aggie receives an enviable compensation package right now. She earns a good six figure salary and her employer gives her generous benefits. Aggie, however, thinks she is carrying her employer and is responsible for its success. She is frustrated that most of her efforts are making others richer instead of herself. She meets with KNow Wear Ltd and agrees to the head of sales job in return for a much lower salary, a relative lack of benefits, but an EMI share option over 10% of the company (after dilution).

Edith agrees to join KNow Wear in return for an entry level salary and an EMI option over 2% of the company. She turns down slightly higher paid positions because KNow Wear Ltd persuasively explains the unlimited potential of her EMI option.

KNow Wear Ltd engages a lawyer to agree a valuation of the option shares with HMRC. The importance of this will become apparent a little later. The lawyer determines KNow Wear Ltd is worth £2m in aggregate. Aggie’s 10% would be worth £200,000 today, Edith’s 2% would be worth £40,000. A “minority discount” is applied however, to reflect the lack of control these small shareholdings have. A discount of say 70% is agreed with HMRC for each option, giving a value today of £60,000 for Aggie’s shares and £12,000 for Edith’s shares. The exercise price for each person’s share option is set at these sums (meaning they benefit in the growth, not the existing value).

The only cost at this stage is the implementation costs for KNow Wear Ltd. There are no charges (tax or otherwise) for Aggie or Edith. There is also no risk - if KNow Wear Ltd fails, they can let their share option lapse.

The company does very well. Five years later a buyer offers £40m for the company and the founders agree to the sale. Aggie and Edith exercise their share options moments before the sale. Aggie’s 10% is worth £4m. Edith’s 2% is worth £800,000. A “cashless exercise” allows the exercise price to be offset from the proceeds, saving either person needing to find material funds in advance of the deal completing.

Aggie pays 10% CGT on £1m of her gain, she pays 20% CGT on the remainder. She walks away with £3,252,000. Edith pays 10% CGT on her entire gain and walks away with £709,200. In reality both probably had an annual allowance which would increase their receipt a little more, but this has been ignored for the purposes of this example. The total tax paid is £766,800. KNow Wear Ltd gets a corporation tax deduction worth £898,320 however, meaning the EMI option is, overall, tax negative.

Compare this to an unapproved share option or bonus calculated by reference to exit value. If the Company had £3,940,000 to pay Aggie (the difference between her receipt and her exercise price), once you factor in employer and employee NIC and income tax (assuming Aggie is paying at the top rate), Aggie would only receive £1,772,229. That is almost half as much. Edith would receive £359,844 (less than half as much).

Put simply, once an employee or potential employee has been persuaded to align their interest to the founders through a share option, making it an EMI option roughly doubles their take home receipt.

This a very brief overview, if the options had been granted at a discount to market value a relatively small amount of employment taxes would be due on exercise of the option (through PAYE in this illustration).

 

Some founders might think they are giving away “their” future proceeds by granting share options. While the option does give away a slice of the company, the intention is that the option incentivises recipients to grow the company larger, such that the founders’ return is still larger than it would otherwise have been. It has also saved cash resources, which will help the company grow and perhaps help it achieve a higher exit price. In this example the other shareholders have still received over £35m. Without Aggie and Edith’s efforts KNow Wear Ltd might only have been offered £30m on sale.

EMI options are intended to help small companies recruit and retain staff. There are many legal requirements and the option contract should not be prepared or tailored without an understanding of the pitfalls. There are quirks which may not be self-evident – to gain the tax benefits the option must include details of restrictions attaching to the shares for example, and cannot be exercisable more than a year after an option holder dies.

Some of the key qualifying requirements for EMI options are:

  • The company must have 250 staff or less (at the time the option is granted);
  • The company must have gross assets of £30m or less (at the time the option is granted);
  • The company must not be controlled by another company;
  • The optionholder must meet a working time requirement, requiring either at least 25 hours a week work for the company, or 75% of their working time; 
  • The company must carry on the right sort of trade (no banks, accountants, lawyers, property developers or property traders for example);

Having incentivised Aggie and Edith to join, and encouraged them to remain with the company and work hard to help it grow, KNow Wear Ltd are going to carry out a review of their customer terms and conditions and data protections policies so they are ready to take the product to market. 

 

ABOUT THE AUTHOR

Matt Spencer is a partner within the corporate and commercial team, specialising in tax law, advising on and efficiently structuring a wide range of corporate and real estate transactions including M&A, land transfers, developments and leases.

 

Lifecycle of a tech startup series

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