Many early-stage businesses offer their employees equity using either shares or options – but what are they offering and what does this really mean?
Issuing options and issuing shares are two similar but very different things.
We get asked about this a lot, as it’s the first time many entrepreneurs take a look at the shares in their business. So we thought we’d explain a bit about the differences. This post aims to explain the differences between the two but please note that Seedrs does not provide legal, financial or tax advice of any kind, and nothing in this blog post constitutes such advice. If you have any questions with respect to legal, financial or tax matters relevant to your interactions with Seedrs or its affiliates, you should consult a professional adviser.
When shares are issued the employee gets an actual share in the company. So as an example, if Lucy, an employee of ABC Company, gets issued 10 shares then she owns 10 shares in the company. Usually shares are issued in return for some consideration such as a monetary investment in the company.
Options tend to be the standard way to compensate employees in terms of equity in early-stage companies. When you see terms like ‘equity offered’ or ‘equity scheme’ on a job posting it usually means options are offered.
When options are issued the employee does not get given shares in the company immediately – instead, they get the right to buy shares at a predefined price (known as the “strike price”), in the future.
If Lucy was issued 10 options at a strike price of £10, she has the right to exercise her options and buy 10 shares later down the line for £10. If the value of the company increases to £100 a share, she can still buy 10 shares at the strike price of £10. Lucy would gain the additional value that the shares have gained over time, so her 10 shares would now be worth £1,000. If she chose to sell the 10 shares at that time, she would make a profit of £900.
Vesting periods, which require employees wait a certain amount of time before they can exercise the options, are not always attached to employee options but are becoming more common. For example, if Lucy was given 1,000 options, ABC Company could attach vesting periods so that Lucy could get 250 options now (which she can exercise immediately if she wishes), 250 after one year, 250 after two years and then the final 250 after three years. If Lucy leaves before a vesting period completes she will not be entitled to those options and they will go back into the total employee option pool. So in the above example, if Lucy left after two years she would not earn the last 250 options.
There are a few reasons why a company might decide to offer options instead of shares:
- Incentive to create value – Offering options motivates and rewards employees for the value they help create. In contrast, issuing shares means that they benefit from the value that has already been created in the past.
- Incentive to stay with the company – Vesting periods encourage employees to stay with the company over a longer time period so that they can earn all options that have been made available to them. In early-stage companies that heavily rely on retaining talent, options can be the carrot that keeps key employees on board.
- Tax bills – issuing actual shares for zero investment could result in a surprising tax bill for employees and might involve some accounting work for the company prior to issuing to help account for any potential large tax expenses that might arise.
- Tax benefits – HMRC offer an employee option scheme called Enterprise Management Incentives (EMIs) for companies in the UK. This reduces the amount of tax the employee would need to pay on their acquired shares.