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Joining a start-up? 10 things you need to know about share options

Posted on 28 September 2022

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Share options can be a key benefit of joining a company. However, they can appear complicated and overwhelming, especially if they are new to you. Here are ten things to consider to get you started.

What are share options and why are they popular?

Share options entitle the holder to receive shares at a certain point in time for a fixed price. Companies don’t always have the money to pay high salaries. By offering share options as part of the pay package, companies can save cash but still attract the top talent. From an employee's perspective, they offer a sense of ownership and can become extremely valuable if the company does well.

Do you believe in the company's potential?

The value of your share options depends on the company's performance. When joining a company, it is common for the company to try and convince you of its potential. The company may provide you with financial evidence that supports this, including recent valuations.

As well as relying on the evidence that the company gives you, you should also make your own objective assessment, especially if you are taking a lower salary. Look at the financial history of the company, its strategy and future plans and also the wider industry. Also consider if the company has been given funding from investors. This can be a positive sign that others believe in the company's potential.

What percentage of the company are you getting?

This is important because it will help determine the value of your share options. Try and understand how the share options are currently distributed amongst existing employees (bearing in mind that it is common for the employee share option pool to make up 10-20% of the company) and what a typical percentage of ownership is for someone at your level.  

It is also important to consider dilution. Dilution is the reduction of each shareholder's proportion of shares because of additional shares being issued. This might happen if the company is fundraising and decides to give a new investor some shares. This is not always negative - you might have a smaller percentage of ownership in a more valuable company which outweighs having lots of shares in a company with no growth prospects.

What is the company's exit strategy?

In a private company there is no readily available market for you to sell your shares. Therefore, you can only usually get value from your share options when there is an exit event such as a sale of the company or an IPO. You need to understand how and when that is expected to occur.

Shares vs. share options

The main difference comes down to timing. Shares provide immediate ownership in the company. A shareholder will get the benefits of the rights attaching to that share immediately including any voting rights or dividends. Shares tend to be issued to founders and investors as they control the business and take on more risk. Share options entitle owners to receive shares when the options are exercised. They are typically granted to employees, as share options can have some tax benefits.

What is all this jargon?

Jargon buster

Share option – entitle the holder to receive shares at a certain point in time for a fixed price.

Vesting – the process of earning share options over time.

Exercise – when share options convert into shares.

Exercise price – the agreed price the option holder pays to acquire the shares when they are exercised.

What is vesting?

Vesting refers to the period of time over which shares are "earned". You do not fully own the shares under option until this period has passed, which encourages you to stay with the company. Share options normally vest over a period of three to five years. Sometimes the company may also apply performance conditions relating to your individual performance or relating to the company's overall financial performance. In this case, the share options will only vest if the performance conditions have been satisfied.

What happens if I leave?

Often, this will depend on whether you are a "good leaver" or a "bad leaver". A good leaver typically includes employees who leave for reasons that are no fault of their own, for example, death, ill-health or retirement. A bad leaver is usually anyone who is not a good leaver. Typically, good leavers can keep and exercise their vested share options for a specified period after termination. Share options held by bad leavers can no longer be exercised and will lapse on the termination date.  However, each option plan is different and you should review these terms carefully.

What tax will I need to pay?

If you are a UK taxpayer, no tax is paid when the share options are granted or when they vest. When the share options are exercised, you will pay income tax and national insurance contributions on the difference between the exercise price and the market value of the shares at the time. When you sell the shares, you may also be liable to pay capital gains tax on any additional profit.

There are some HMRC approved plans which give certain tax advantages. EMI (Enterprise Management Incentive) plans are one of these and are commonly used by start-ups. If used correctly, you will not pay income tax or national insurance contributions when the EMI option is exercised. Capital gains tax can also be paid at a lower rate when the shares are sold.

What documents should I expect?

Typically, there will be option plan rules which govern the terms of the plan. The rules will also usually include a template exercise notice which you can use when you want to exercise your option. There will also be an individual award agreement which is personal to you and which will set out any specific conditions such as vesting or performance conditions.

The Mishcon Incentives team are here to help. As share option documents can be complicated it is best to get them reviewed so that we can explain how they apply in practice. We can also help you negotiate the share option terms so that you get the maximum benefit of these in the future.

 

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