The right time to set up your incentives scheme is when you need it; at the point when you want to be able to attract high calibre employees. Many startups, however, delay setting up their schemes for an unnecessarily long time because the process seems complicated and costly.
And yet, it’s easy to put off setting up options schemes because the process seems complicated and costly. In this article, I will attempt to demystify the process of setting up a scheme and get you clued up to avoid any unnecessary fees.
Choosing your scheme
Although there are other possibilities, in practice the most popular and effective choice for nearly all start up businesses is the Enterprise Management Incentive (EMI) scheme.
Employee share schemes can be split between those “approved” by HMRC and those “unapproved”.
“Unapproved” schemes do not benefit from the same tax benefits that “approved” schemes do and given that the goal of your scheme is to incentivise your employees, they are rarely used.
There are four HMRC approved schemes and, of those, EMI is most widely used in startup land as it provides the most flexibility for employers in terms of setting out scheme rules as well as the maximum tax benefit for employees.
Under EMI, employees pay no income tax or national insurance when they are granted or exercised and they pay reduced capital gains tax of 10% at the point of sale (i.e. the difference between the exercise price they’ve paid and the sale price).
Setting up EMI
To use EMI, the company must be limited by shares, be independent, have gross assets of less than £30m and have less than 250 employees. It must also not be in one of a few areas HMRC judges as “excluded activities”, including property investment, banking and insurance. However, this should not affect most typical startups.
Setting up an EMI scheme is a technical process that includes the setup of an options pool, drafting of legal documentation, and contact with HMRC for valuation and correct filings.
Typically, these require specialist solicitors or accountant advice to perform accurately, and while you could set up a scheme without advice, doing so will take up time and energy with the risk of a serious mistake that could be costly to the company and your employees.
However, having a clear idea of how you want it to look before you take advice will save you time and money. With that in mind, and depending upon the complexity, you shouldn’t need to spend more than £2 - £3k on fees to set up your scheme.
To help you define your scheme rules solicitors / accountants will typically provide a questionnaire and / or talk you through some standard scheme rules. They will then apply the rules you define in a Scheme Rules document to which the Options Agreement will relate.
At the end of this article, we’ve included the types of questions they will ask and some guidelines to help you to be prepared before you speak with an advisor.
Another key activity that an advisor will help you with is applying to HMRC for a company valuation. The valuation sets the floor at which the exercise price for options can be set and, if your goal is to maximise the benefit to your employees, then it will be at the valuation.
(There are reasons why you might choose not do this, but that’s for another article.)
Suffice to say, valuations set by investors are based on potential. If you’re setting up your scheme early and before you’ve created significant value, then it stands to reason that HMRC will accept a valuation at or towards the nominal value of your company shares.
You shouldn’t need an especially complex argument set out by a solicitor / accountant to achieve this.
The valuation will apply for 60 days from the point at which it is agreed with HMRC and you’ll need to allocate options to employees within this window. You therefore need to apply for a valuation every time you want to allocate options and, although the time and financial cost of applying for a new valuation is less than the full process of setting up the scheme, it makes sense to allocate options in blocks when you have a number of employees to allocate to.
Preparing your Incentives Scheme Rules
Here are some of the key rules that you should be thinking about before you set up your incentives scheme. It’s not an exhaustive list, but should be enough to get you started.
Over what period of time do you want to give options to employees? To incentivise employees on an ongoing basis, companies normally set up options to vest over a period of time. A typical vesting schedule is over 4 years in equal monthly tranches.
Do you want to make sure that your employee is with you for a period of time before they vest anything? Within your vesting schedule you may want to include a “cliff” whereby an employee doesn’t vest any options until they’ve reached a certain point of time. It’s typical for this to be after 1 year.
A 4 year vesting schedule with a 1 year cliff means that an employee has vested none of her / his options before 12 months of service. On the day of 12 months service they have vested 25% of their allocation and they continue to vest the remainder of their options in equal monthly installments over the following 3 years.
Do you want your employees to be able to exercise unvested options at an exit event? i.e. if an employee has only vested 50% of their options at the point of an exit can they only exercise their vested 50% or their total allocation?
Exercise Timing Rules
At what point do you want your employees to be able to exercise their options? For employees remaining within the employment of the company this is usually only at the point when they are fully vested or when there has been an exit event. Limiting to the point of an exit event will avoid the administrative untidiness of having a load of minority shareholders.
One caveat to this is that EMI options lapse after a period of 10 years so you will need to include a provision whereby options can be exercised in advance of exit but before lapse.
What happens to the options if an employee leaves employment? This is perhaps the most thorny decision to make. It’s typical for companies to leave this at the Board’s discretion and this is normally done by having bad leaver and good leaver provisions.
Bad leavers are employees who leave for reasons of gross misconduct or otherwise who are defined as bad leaver at the discretion of the board. A good leaver is anyone who isn’t a bad leaver. Bad leavers are not allowed to exercise their options. Good leavers typically have a stated period of time to exercise their options from the date that they leave the company.
Got more thoughts or questions on this topic? Continue the conversation and have your say.