Options – is EMI always best?
It is quite common to be asked ‘How do I set up an EMI scheme?’. This usually comes about from clients who have decided that it would be beneficial to the business to include certain employees in its ownership, and then a huge leap is taken to the conclusion that an EMI scheme is what they need.
There is no doubt that the EMI code is in fact quite well written, being both generous and flexible. However, as with most things in life, what is perfect for one person might not fit as well on you.
How do share options work?
A share option agreement is a legal contract between the company and the employee, either as a stand-alone contract or by reference to a set of scheme rules.
The contract literally gives the employee the option to acquire the stipulated number of shares at the required (exercise) price, possibly conditional upon certain events happening. Examples of so-called ‘vesting conditions’ include: the expiry of a qualification period, hitting performance targets or a sale of the company.
In the meantime, and for so long as the optionholders have not exercised, they do not own those shares. This means that they have no votes and no rights to dividends. They also have nothing that needs to be bought back should they leave. At the same time, they have not committed anything to the company and can simply walk away even if the company value has fallen.
Once the options are exercised, the opposite is true.
So why don’t I just give them some shares?
You could indeed just to skip over the step of issuing options and instead just give some shares direct. There are two main reasons why in practice an option scheme could be better:
- Options allow you to set vesting conditions.
- The employees might not be able to afford to pay market value for the shares.
Show me an example
The sole shareholder of Company A decides to incentivise two key staff to grow the value of the company, ready for its sale in three to five years’ time. A baseline valuation of £1m is agreed (roughly equal to today’s open market value) and each optionholder gets to have 10% of the sale proceeds in excess of £1m but only if the company is sold in the next 5 years.
An option works well here. Unless and until the sale of the company happens the current owner keeps her 100% share ownership intact, only losing it at the point of sale. The optionholders do not need to put any of their own cash up to finance the purchase of the shares.
What are the tax benefits of EMI options?
With all share option schemes, the grant of the option does not give rise to any tax liabilities.
There is a tax point when the options are exercised and it gives rise to a liability to income tax, which in some cases falls under PAYE and National Insurance. For unapproved schemes the taxable amount is the difference between the market value on the date of exercise and the price paid for the shares. For EMI schemes the taxable amount is the difference between market value on the date of grant and the price paid for the shares. Most EMI schemes set their exercise price at the value pre-agreed with HMRC at the date of grant, with the result that there is no tax to pay on exercise. When the shares are sold, fingers crossed, there is a capital gain.
This gives EMI schemes two big advantages over unapproved options:
- Basically, all of the profit on sale is liable to capital gains tax, rather than income tax (at up to 45%), plus possibly two lots of NICs.
- The shares can qualify for the 10% rate of CGT under entrepreneurs’ relief without the optionholder needing to have held the usual 5% of the shares and votes for the last year.
We should also mention the corporation tax relief that the company attracts when the share options are exercised. The company can take a deduction against its taxable profits amounting to the difference between market value on exercise less the amount paid (or assessed on) by the employee.
When could a simple gift of shares be suitable?
Not all companies meet the qualification criteria to be able to issue EMI options. The major factors that might prevent qualification for EMIs are
- the independence requirement;
- the working hours requirement;
- the gross assets limit for the company or group of £30m, and
- the restrictive qualification with regard to trading which eliminates, among others, certain businesses in the financial sector, property developers and certain ‘property-rich’ businesses, and accountants.
Some companies have no particular plans to sell, but they still want to have employees invested in the business, possibly with half an eye on some longer-term succession. So they need to become shareholders in short order, so why bother with an EMI scheme? The only tax benefit of immediately getting shares to an employee via EMI is the ability to qualify for entrepreneurs’ relief despite not meeting the 5% tests.
What other schemes can be used?
|Type of scheme||What is it?||When is it used?|
|Share Incentive Plans||An all-employee scheme||Mostly used by quoted companies|
|Company Share Option Plans||A selective scheme with some similarities to EMI||For companies that exceed the £30m gross assets test for EMI|
|Partly-paid shares||The employee is required to pay full market value for the shares, but only puts up say 1% of the total initially||For valuable companies that do not qualify for EMI (eg property investment companies) or where we would need the option to be exercised quickly|
|Growth shares, including joint ownership plans||The employees get shares whose value only accrues above a set price||The low market value of those shares today makes it easier to get them to the employees now with limited tax cost|
|Sale or gift of shares||The employee acquires the shares direct for an agreed discount||Companies whose current value is low and where we want them to be actual shareholders rather than just optionholders|
|Phantom share schemes||Not a share scheme at all, just a cash bonus scheme designed to pay out broadly the same as if the staff had been shareholders||A simple scheme giving actual benefits each year, where tax-efficiency is not crucial|
There are so many different ways to get shares to employees that it is not possible to list them all. The design of any good scheme will start with a thorough discussion of the company’s aims and objectives. The tax benefits of EMI mean that it is used maybe nine times out of every ten when it can be used. Still, it would be brave (or reckless) to go for an EMI scheme without first exploring the alternatives.