Founders are often aware of the need for a ‘share option scheme’. They may be less familiar with how to actually make one happen (see previous blog post). Confusing jargon doesn’t help, so let’s unpick the key terms and identify some sources of support for setting up a scheme and proceeding to grant options.
Fully Diluted Capital: Investors usually think in terms of fully-diluted share capital because it better reflects their true ownership position. In this calculation, you take account of all issued shares, issued options, issued warrants and options reserved in the option pool as well as any instrument which could ultimately be converted into shares in the capital of the company. In other words, you assume the entire option pool is granted and all issued warrants and options are exercised.
Issued Capital: This will typically be a smaller number than the fully diluted capital. Issued shares means exactly that: the number of shares actually issued by the company to shareholders. In the UK, the shareholders’ register should show you exactly how many shares have been issued and to whom. Outstanding options, for example, are not included in this calculation because they only represent a right to purchase shares in the future, subject to certain conditions.
Share Option Pool: This is the total available ‘bucket’ of shares which may be granted to employees, both existing and future. Typically, earlier joining or more senior employees will get a greater percentage of options awarded to them than their later joining or more junior colleagues.
Allocated: An allocated option pool has been earmarked for specific employees.
Unallocated: An unallocated option pool has no particular employee’s name next to those shares.
Share Option grant: A contractual right (not an obligation) granted to an employee to buy shares in the company at a particular price (the “exercise price” or “strike price” — see below) on a particular date, or before a particular date (also known as the vesting date), or upon certain conditions being fulfilled.
Exercise: This is when the employee is able to put into effect the contractual right they have been granted under their option agreement.
Strike Price: The price per share at which the employee is entitled to buy the shares the option has been granted over. In the UK, you need HMRC to agree a valuation of the shares in the company. Your most recent fundraising will be the starting point for HMRC but your valuation advisers should be able to agree a discount of up to 70%-90% of the market value of these shares, subject to the rights attaching to those shares.
EMI Scheme: In the UK, employee share schemes can take many forms, but at start-up stage, it is most common to establish a tax-advantaged scheme known as an enterprise management incentive scheme (EMI). This type of scheme is targeted at smaller, higher-risk trading companies. It attracts significant tax benefits for both the company and the employee. There are specific requirements for a company to be able to grant EMI options (see http://www.legislation.gov.uk/ukpga/2003/1/schedule/5) and unsurprisingly, there is overlap between these requirements and those which regulate which investee companies EIS, SEIS and VCT money can be deployed into.
Vesting: Typically, employee options are accompanied by a vesting schedule. This will set out a period of time during which the employee must continue to be employed before they are entitled to exercise their right to buy shares in the company. A frequently used vesting schedule is 4 years, with a 1 year cliff (see below).
Cliff: Using the above example of a 4 year vesting schedule with a 1 year cliff, if you award an employee options over 240 shares in the company, they will not have a right to exercise this option at all for the first 12 months after the award. As soon as the 1st anniversary of their award passes, the employee immediately becomes entitled to exercise 25% of their total award, or 60 shares. These 60 shares are then “fully vested”. After that, for each month that the employee continues in employment until the 4th anniversary of their award, 5 of the underlying shares will become fully vested, until all 240 shares are fully vested. There are divergent views on the 1 year cliff. Some employees think they can end up being gamed with this tool (and get fired in month 11, losing all of their options). Others will work harder to prove their worth during this “cliff” period. You should perhaps consider whether you ever want to be in a position where all of your employees’ options are “fully vested”. This almost means they have nothing left to work for, so you may want to consider topping up your option grants at regular intervals, with each option grant subject to its own individual vesting schedule.
Leavers: What happens to options if an employee leaves? You will come across the concept of a ‘good’ leaver and a ‘bad’ leaver. Typically a ‘bad’ leaver’s options (whether vested or not) will automatically lapse, meaning they can never be exercised. On the other hand, a ‘good‘ leaver will usually be able to retain their options, either the vested portion, or all of them. A great deal of time can be spent negotiating what compromises a good or bad leaver. (For example, should someone who resigns for family reasons really be called a ‘bad’ leaver?) The reality often is that the Board will discuss the departure of a particular employee and decide what they consider to be just and equitable in the circumstances with regard to their options.
Single Trigger: What exactly is being “triggered”? An acceleration of the vesting schedule so that all options become fully vested. “Single trigger” means that a single event happens to cause the accelerated vesting. The most typical single trigger event is the sale of the entire company and is designed to reward the employee for their contribution to what should hopefully be a successful outcome for the company. The main issue here is that any potential buyer of the company may be put off by the single trigger clause because of the impact it will have on their acquisition, retention of key team members and their financial ability to motivate such team members post acquisition. Alternatively, a single trigger event may be the termination of the employee’s employment with the company (which is not initiated by the employee). This is less common because it can be a serious obstruction to the company’s ability to let go of employees. Overall, a single trigger acceleration is not very common due to its potential to be unattractive for future acquirers.
Double Trigger: The same thing is being triggered, namely an acceleration of the vesting schedule. However, this is more nuanced and typically reliant on two events happening: (1) the sale of the business; (2) the termination of the employee, whether by the employer for no good reason or by the employee due to a pay-cut or change in their role since the acquisition, usually within a certain period after the sale (e.g. 12–18 months). This is more popular with start-ups. It provides comfort to employees who may be removed during a post-acquisition integration phase where a buyer would otherwise be weighing up the cost of finding a replacement employee against the value of the unvested equity. Unlike a single trigger, it is more acceptable to a prospective buyer. They may still want ongoing employment to be a condition of vesting and can therefore control any acceleration. If they choose to let go of an employee post acquisition, they know that accelerated vesting will be the consequence of this.
We can recommend the following advisers who we and our founders have worked closely with:
Tax specialists: Philip Hare http://philiphareassociates.tax/about-us/
Valuation Advisers: Ralph Knight / Tony Hindley http://www.valuationsolutions.co.uk/meet-the-team/