Demystifying Share Options

Employee options are one of the most exciting benefits a start-up can offer its team. They offer a way for start-ups to provide employees with an ownership stake in the company. Share options are an excellent way for start-ups to power up the team with an attractive reward and incentive package.

If you are looking to scale your start-up, it is important to have a clear understanding of share options and how you can leverage these to incentivise employees and attract and retain the best talent.

In this blog post, we will take a deep dive into the world of share options, exploring the key benefits and downsides, and discuss how founders can use them to achieve their business goals.

What are Share Options?

A share option is a contractual right to purchase a specified number of shares in a company at a predetermined price.

Options are not equity but instead are a right to acquire shares at a future date, most likely when the business is sold. By holding share options, employees can participate in the growth of the company and share in the financial rewards at exit.

Share options are a neat way to reward high-performing employees without giving away equity too early. As a founder, you are giving a mechanism for employees to enjoy the rewards of a growing business valuation without giving away ownership too early.

Unlocking the Power of Share Options

Options are attractive to founders and employees alike. The key benefits are:

Attract and Retain Top Talent 🌟

Share options can be a game-changer for your employees, consultants, and advisors giving a share of the business valuation and an opportunity to cash in at exit.

Options are a key component of remuneration packages, making working at a start-up attractive to top talent.

Maximise Employee Benefits without Breaking the Bank 💰

Elevate your employment packages in a cost-friendly way with share options. Although it requires a small investment to set up and maintain the scheme, the rewards for your employees far outweigh the initial cost. By strategically implementing share options, you can enhance benefits without draining your precious cash flow.

Boost Productivity 🚀

Want your team firing on all cylinders? Give them a stake in the game. By offering share options, you create a powerful motivational tool. After a certain period of time or when a milestone is achieved, employees can exercise their options, giving them a vested interest in the company's success. The result? Increased drive, focus, and dedication from your workforce.

Who can get Share Options?

Who can receive share options? Employees, advisors, consultants, and suppliers can be eligible and share the benefits.

For Employees:

Share options are a popular way to attract, retain, and motivate talented employees. Founders will want to consider how much equity will be on offer.

Typically, start-ups set aside 10% - 15% of total company equity as an option pool. Quite often the first option pool is set up with the first investment round.

For Advisors, Consultants, and Freelancers:

Share options aren't just for employees. You can also entice skilled advisors, freelancers, and contractors to join your company by giving them equity.

A good starting point for advisers and freelancers is 0.5 – 1.0% of the equity.

For Suppliers:

Sometimes it makes sense to reward suppliers with share options as a means to keep costs low in early-stage businesses or before a funding round.

Keep in mind that this may be an expensive way of paying for services as you potentially give away a much greater sum of cash when you share a percentage of ownership when the business is sold.

What are the Downsides of Share Options?

Often overlooked by founders, share options do come at a cost and there are a number of downsides to consider:

Dilution:

One of the most obvious risks of share options is dilution of the founders’ ownership stake. As more equity is offered to employees and investors, the founders' equity can be diluted and lowering future proceeds on sale of the business.

The impact on founders from dilution at exit should be offset by the value generated from incentivised employees and advisers. Founders want to consider the vesting terms and conditions of share options to ensure that employees are incentivised over the longer term and rewards are aligned with valuation growth.

Valuation:

The pricing of share options involves a steep learning curve for many entrepreneurs. Options are granted at a given value, which means their worth fluctuates with the company's share price.

That said, valuing the options is often a matter of educated guesswork, which can result in either overvaluation or undervaluation. Both can have significant repercussions on the company's financial health and the founders' position. Therefore, before granting options, it's essential to conduct market research and valuation exercises.

Financial Burden:

Starting a business is a financial burden for most entrepreneurs. Although share options are a powerful tool for employee retention and motivation, they can still add to the initial cash burden of the company.

Plus, to manage share options, you will need to process accounting costs, legal fees, and administrative costs, which will add up over time. To mitigate this risk, be sure to budget for these expenses upfront, so they do not surprise you at a later date.

Tax Implications:

Share options are taxed differently depending on the type of options and who they are granted to.

In the UK, share options can either be approved or unapproved. Approved share options such as EMI are tax advantageous for the company and employees alike.

Tax on share options can be a minefield and it’s an area that is always looked at closely during due diligence for a sale or funding round. It’s always a good idea to get sound tax advice before proceeding with share options.

When is a good time to set-up Share Options?

There are no specific timelines for setting up an option scheme but typically you will do this when your team starts to grow or as part of a fundraise.

Investors typically ask businesses to set-up a share scheme after a funding round. This is to mitigate the impact of dilution on the founders and to incentivise the key team.

The timing of share options can be critical, especially for approved schemes in the run-up to a sale or a funding round. It’s always a good idea to keep on top of your share schemes and gets options issued promptly once the decision has been made to set up a scheme.