What are share options?
Share options grant employees the right to purchase the company’s shares in the future at a specific price. The price is known as the ‘strike price’ or the ‘exercise price’.
The idea is that by the time they exercise the option, the company will have become more established. As such, its shares would be worth more than the strike price. Hence, it will be very advantageous for employees to be able to purchase the shares at the predefined strike price.
Typically share options are offered as part of an employee share scheme, commonly through the Enterprise Management Incentive (EMI) share scheme.
What is the difference between shares and share options?
The difference between shares and share options lies in the ownership of the company and the vesting method.
Ownership in the company
Once shares have been issued and allotted, the individual immediately becomes a shareholder and enjoys the rights of shareholders (eg voting rights and rights to dividends).
On the other hand, an individual granted with share options doesn't become a shareholder immediately. Instead, they’re granted with rights to buy shares in the future (after a ‘vesting period’) at a set price. They must exercise the options to convert them into shares.
Vesting refers to a process where an individual’s entitlement to the relevant shares or options is granted over time. This mechanism prevents shareholders from suddenly walking away with a large stake in the company, rendering the company not investable. It also encourages employees to stay with the company longer so that they can fully earn the options available to them.
Shares typically vest by reverse vesting. This is where individuals become shareholders immediately upon allocation. However, if they leave before a defined (vesting) period, they will be required to sell the unvested shares back to the company.
For example, John is issued and allocated 1,000 shares with a reverse vesting period of 5 years. This means 200 shares are vested annually. If John leaves after 2 years, the company can repurchase the 600 shares which haven’t been vested yet.
Options vest by forward vesting. This is where individuals are granted options gradually over a specific period.
For example, John is rewarded with 1,000 options with a vesting period of 5 years. This means 200 options are vested annually. If John leaves after 1 year, he will only be entitled to 200 options. The remaining 800 unvested options will return to the total employee option pool.
What are the benefits of issuing options instead of shares?
Although directly issuing shares may be cheaper and easier to set up, issuing options may be more desirable for the following reasons.
More capital generated
Shareholders pay when the shares are allocated to them, generally at nominal value (ie the price for which they were originally sold). This is usually lower than the market value, which fluctuates and reflects the shares’ worth on the market. The difference can sometimes be extreme and in most cases, shareholders pay close to nothing for their shares.
In contrast, option holders pay when they exercise their options to buy the shares at the strike price. This is usually the market value of the shares at the time the options were granted. As such, although payment is made at a later stage, more cash is generated.
When shares are allotted at a nominal value, the difference between that and the market value will usually be subject to income tax and national insurance contributions (NICs). HMRC will determine the market value with the trading history of the company or the most recent investment round. This may not apply to companies at an early stage where shares have no value at the time of allocation.
Options issued under four types of HMRC-approved employee share option schemes enjoy tax advantages. For example, the EMI option scheme benefits both the company and the option holders.