Competing with corporates; navigating the world of Share Option Schemes at Series A
Employee Share Option Schemes (ESOPs) are important components of a company’s compensation strategy, and even more so at the early and growth stage. They require planning and careful consideration.
At a basic level, share options are a way of sharing company ownership with the wider team. It gives employees the right to purchase shares at a typically low specified price, by a specific date, in a promising early-stage business. The employee is under no obligation to buy, or “exercise”, any of their options.
- Increase employee performance and productivity by aligning the business objectives (i.e. growth in the value of the business) with its employees, and by increasing employee motivation;
- Ease cash flow pressures by channelling a business’s limited capital to other activities, and allowing greater flexibility on managing total compensation; and
- Retain talent by increasing staff loyalty.
What can go wrong?
There are potential downsides to consider. For example, share issuances dilute existing shareholders. As Joe Ancer wrote in his blog, “no amount of friendliness changes the fact that every cap table adds up to 100 per cent.” But with the right tools, you can see the impact of each dilution, to make sure you’re making the right decision.
There is an administrative burden in setting up and implementing a share plan. Companies like Global Shares can make this easier and more cost-effective.
Which share schemes are best for early-stage businesses?
In order to benefit from the tax advantages provided by HMRC (for UK companies), your scheme needs to be approved. The most common scheme for early-stage companies is Enterprise Management Incentives (EMI).
The key benefit of these schemes is that employees can enjoy a reduced capital gains tax (10%) on the increased value of their shares, without having a cash tax impact upon issuance.
For a closer look at EMI schemes, have a read of this post.
How do I set one up?
Before you do, it’s vital you understand your cap table. It should always include the actual number of shares, percentage ownership, and value of equity in each round of investment.
Setup costs typically start at £5,000 for EMI schemes. It’s important that your EMI plan integrates with the rest of your company’s legal structure. Be sure to have a legal advisor review the EMI alongside your existing company formation documents, or you run the risk that your EMI will not be valid.
There’s a lot that goes into setting up an EMI scheme — creating the scheme, filing for valuation from HMRC, authorising and granting the options, then registering the scheme with HMRC.
- Who gets them? Rewarding only stand-out performers can act as a catalyst for high achievers — but this may also discourage those lower down the ladder. Offering equity to everyone can lead to greater commitment across the organisation and indicates faith in every employee. What kind of organisation do you want to create?
- How much equity should be given away? This will depend on the available capital in the share option pool and how critical the individual is to the company. At Series A, 10–15% is typical for employees outside of the founding team.
- When should the shares be valid? Vesting is a common retention tool whereby an employee doesn’t have access to the full amount of shares until a certain period of employment has elapsed. Founders implement this as they want to see loyalty to their company before employees can reap the benefits of their options. Typically, vesting occurs over a four year period.
- How do they access them? Employees need visibility and control over their equity. Using an online portal can ensure they know how much their benefit is worth.
Founder’s tip: Talk in value instead of percentage when allocating small proportions. £30,000 of a £15m valuation sounds much more attractive than 0.2%.
Vesting explanation via a calculation — 4 year vesting with one-year cliff
You award 960 shares to an employee in the company. They will not have the right to act upon the shares for the first year, known as the cliff period. After the first year has elapsed, the employee becomes entitled to exercise 25% of their allocation, or 240 shares, which are now “fully vested”. For each month the employee stays in employment after that until their fourth-year anniversary, they will receive 20 underlying shares, until all 960 are fully vested.
For founders — negotiating share options with your investors
- Before signing your funding term sheet, discuss your share option scheme with your potential investor. When it comes to share options, the biggest negotiation point that you will be discussing is the proportion of your option scheme that will be reflected in your pre or post money valuation. Further details below!
- The opportunity cost of an incentivised workforce at the expense of diluting shares is one that investors understand. Motivated employees are an extremely important part of an early-stage business.
- Come prepared with a realistic plan for who you want to hire, and an estimate of how much the hires will cost. Don’t just agree to an investor proposal if it’s not accurate — this will only devalue the business’s share price.
- Similarly, don’t under-serve the pool — you are only asking for trouble later.
- Leave some headroom for “opportunistic hires” in case you happen to find an “ideal candidate” for a role and want to bring them on prematurely.
Investors often ‘shuffle’ the option pool so it is set out in the pre-money valuation — diluting the existing shareholders. The option pool also represents a higher proportion of pre-money than one thinks, even though it seems smaller because it is expressed as a percentage of post money. By negotiating for your option pool to be in your post-money valuation, both you and the incoming investor will be diluted.
Therefore, finding the right balance within your option pool that is reserved for employees who are already working with you vs future unnamed employees will be key to determine this allocation.
- Investor friendly example: £1m new options ÷ £4m pre-money = 25%
- Founder friendly example: £1m new options ÷ £5m pre-money = 20% (i.e. putting the option pool in the pre-money)
A further complication is included when the new funding round also triggers the conversion of a convertible loan note. The maths can get tricky but there are tools and resources that can help.
For employees — negotiating share options
- Do your diligence on the market. Is equity expected in the industry?
- Do your diligence on the company. What was the company’s valuation at its latest funding round? Who owns the equity currently? What are its growth projections? Equity within a company is worthless if it doesn’t lead to a liquidation event.
- Consider how valuable you are to the company. You clearly have some value to them, because if you didn’t, you would not have been hired.
- Consider your own career aspirations. How long do you expect to be working at the company?
- Understand the terms and conditions of the shares you are receiving before agreeing to a plan.
- Consult with individuals in your network, or existing employees, and don’t be afraid to ask questions.