The commercial imperatives of a tech start-up are rarely unique; its primary concerns are to develop a minimum viable product, establish a place in the market and gain traction with its customer base. However, in an attempt to do so, start-ups are usually posed with the same challenge: making the business a success on a limited budget.
A start-up’s seed funding, whether self-funded, raised through family and friends, a third party investor or by crowdsourcing, is only ever going to stretch so far. In view of this, it is crucial that financial resources are allocated as effectively as possible.
When a business is in its infancy, it is unlikely to have sufficient funds to pay its key employees high salaries (or even market-rate, for that matter) or award generous bonuses. Equally, there may be good reasons why existing shareholders would be reluctant to immediately give equity in the company to its employees.
A share option is the right to acquire shares in a company at a pre-determined exercise price, which usually become exercisable on the satisfaction of certain conditions. On exercise of the options, the person to whom the option was granted (the “option holder”) would be allotted shares in the company. Share options can be a cost-effective way to align the interests of a company’s employees with its shareholders, in order to ensure that employees are vested in increasing the value of the company.
Enterprise Management Incentive (“EMI”) options are a specific, tax-advantaged share option arrangement targeted at small, higher-risk trading companies. Given the risk-profile of most tech start-ups, EMI options are often the most effective way to assist with the retention and recruitment of employees.
EMI options are granted subject to detailed rules set out in an EMI option plan, which would usually include how and when the share options can be exercised, what happens on termination of employment and any other applicable terms. For an EMI option to qualify for favourable tax treatment, the option plan and grant of option must also be notified to HMRC.
Who can grant EMI options?
Broadly speaking, a company will be a “qualifying company” entitled to grant EMI options if:
- it is independent (i.e. not a 51% subsidiary or otherwise under the control of another company);
- any of its subsidiary companies are “qualifying subsidiaries” (i.e. 51% subsidiaries of the company);
- the consolidated value of the group assets, without deduction of liabilities, is not more than £30,000,000;
- it carries out one or more qualifying trading activity (note that a tech start-up would usually fulfil this requirement);
- it has a permanent establishment in the UK; and
- the group employs fewer than 250 people.
In addition, the total value of the shares in a company subject to unexercised EMI options must not at any time be more than £3,000,000, and the individual EMI option holder’s maximum entitlement at the date of grant of the EMI options is £250,000.
Who can EMI options be granted to?
EMI options can be granted to “eligible employees”, namely those who:
- are employed by the company or any of its qualifying subsidiaries;
- are committed to work at least 25 hours a week or, if less, 75% of his or her working time; and
- do not (either individually or jointly) have direct or indirect ownership of more than 30% of the ordinary share capital of any group company.
Benefits of EMI option shares
There are many reasons why a company might want to grant EMI options, and unsurprisingly, those options can be very valuable to the recipient employees.
Perhaps most importantly from the employee’s perspective is the tax treatment of EMI options. Generally, there is no income tax liability on grant or exercise of the EMI options (unless the exercise price is less than the market value of the shares at grant).
Upon disposal of the option shares, any gain made on the shares (that is, any difference between the amount paid for the shares and their market value at the date of grant) would usually attract capital gains tax, rather than income tax, which has traditionally had a more favourable rate. Subject to certain conditions, the option holder may also be entitled to entrepreneurs’ relief at the even lower rate of 10%.
From the company’s point of view, granting EMI option shares to employees can be a cost-effective way to remunerate employees in the long-term; invaluable to a company still in its early stages operating on a shoe-string budget.
An equally important, but perhaps less obvious benefit, is the potential appeal to outside investors. Investors who are considering investing in a tech start-up are likely to scrutinise the commitment of key staff, whose know-how and expertise are central to the potential of any start-up. An EMI option plan is likely to be well-received by investors as it indicates a recognition by the company of the importance of retaining its key personnel.
Finally, companies have considerable flexibility in determining the terms of the options. EMI option terms are only subject to a handful of prescribed requirements under EMI legislation, meaning that the company is generally free to decide how the EMI options are exercised, when they lapse and what (if any) exercise conditions will apply.
For example, a company may wish for the option shares to vest with the employee over a number of years, to lock them in for a minimum period, before they can be exercised. Alternatively, the company may want to include good leaver and bad leaver provisions, setting out what happens if an employee leaves the company. In these circumstances, it may be that a “good leaver” (for example, an employee who can no longer work as they are injured) is entitled to exercise the share options for a certain period after the end of their employment.
Why granting EMI options may not be appropriate?
Invariably, granting EMI options will not be suitable for all businesses in every scenario. Whilst the option terms can be flexible, there is still extensive qualifying criteria that must be met, meaning that certain companies will not be eligible to grant EMI options.
The fact that EMI options cannot be granted in respect of shares in subsidiary companies may also prove problematic. In circumstances where there is a group structure, shareholders of the ultimate parent company may be reluctant to grant share options in that parent company, which on exercise would have the effect of diluting their control. Although it may be more desirable to grant EMI options in a subsidiary company, this is prohibited under EMI legislation.
Finally, the option holder must have the necessary funds to pay the exercise price. If the exercise price is particularly high, it may not be viable for the option holder to raise the funds to do so, which could potentially undermine the intended effect of the EMI options.
Whilst EMI options are unlikely to present a one-size-fits-all solution for tech start-ups, there are a number of unique benefits that granting EMI options can offer to both employee and company. For employees, they provide an opportunity to participate in the growth of the business in a tax-efficient way, which has the potential to be lucrative in the long-term. Conversely, EMI options are a cost-effective way for the company to ensure that employees are properly incentivised to work hard to increase the value of the business. For tech start-ups, EMI options could be a particularly useful way to hold on to key staff without depleting limited funds.
Note: the content of this article is for general information only and does not constitute legal advice. Specific legal advice should be taken in any specific circumstance.
If you have any questions on any of the points covered in this article, please do get in touch with our Corporate & Commercial Team on 01603 610911.