Making sense of employee options schemes
Options schemes are a great recruitment and retention tool for any startup. If you run a fast-growing startup, and your employees are key to your future success, then share option schemes are certainly worth thinking about.
We were fortunate to attend a webinar organised by Seedlegals about this particular topic. Here we detail key insights and our thoughts on this.
Why should I give staff equity?
Offering equity in your startup to employees through a share options scheme can be a real win-win. The two advantages:
You get to attract and retain high-quality talent before you’re able to pay corporate salaries
And the employees have the potential of receiving a life-changing amount of money if you later go public or get acquired
Equity is widely used as a recruitment and retention tool within American tech companies, but it’s traditionally been less popular in the UK. This is starting to change. The UK government’s enterprise management incentive (EMI) scheme is the most popular route for offering equity to staff.
In 2018, 50% of companies on the company’s platform who were raising funding had reserved an ‘options pool’ of shares to allocate to staff. In 2020, it’s up to 90%.
Shares V Share options
There are two ways of giving equity to your team. The first is to simply allocate shares on your cap table. The second is options.
OPTIONS
SHARES
Best done right at the start of your company’s journey
Before you’ve generated revenue or raised external investment
Shares have no value from the viewpoint of HMRC, so there are no income tax implications from allocating them
Most common for seed-stage companies under 2 years
Options giving staff the option to buy shares in the company at a later date, at a pre-agreed price
Assuming your valuation goes up through investment rounds and the success of your business, your employees will eventually get a generously discounted rate on owning shares.
This incentivises them to stick with you until those options ‘vest’ (the point at which they can exercise their right to buy the shares). Options reduce and defer tax liabilities on the employee, too.
Most suited to Series A, B, C stage companies.
How big should my options pool be?
Options aren’t ‘real’ shares until they’re allocated to specific employees. Instead, they consist of a percentage stake in the company (the ‘pool’) agreed among existing shareholders. If you’re raising external investment, you may well agree on an options pool with the investors, diluting the pre-money shareholders’ stake in the company to create it.
Factors to consider
Do you want to be fair?
Do you want to be competitive - versus what other companies in the market are offering?
Your hiring plan - how much hiring you plan to do over the next 12-18 months
Whether you’re going to give equity to all employees or just key hires
How much equity should employees receive?
There is no simple answer to this question, but typically, the earlier an employee joins the company, the more equity they should receive.
From our experience, in many companies, C-suite executives will receive around 2.5%, while junior employees may receive around 0.1%. These numbers can differ based on factors like the size of the company and the amount of investment raised.
But don’t pick numbers out of thin air when it comes to allocating equity. Plenty of work has been done in this field that you can learn from. For example, Index Ventures’ OptionPlan.com; Fred Wilson’s methodology, and Wealthfront’s framework. Learn from these guides, let them help you shape a structure that works for you, and then stick to it.
How do options schemes work in the UK?
As mentioned above, the UK government’s EMI is the most popular way of setting up an options scheme. It’s the most tax-efficient approach for employees. In most cases, they’ll pay no income tax when they exercise their options and buy their shares, but when they eventually sell their shares they may have to pay capital gains tax.
There are specific rules about what kinds of companies can set up EMI schemes, and which staff they can offer options to. Seedlegals offers a guide that explains these rules. If your business doesn’t qualify for EMI, other schemes are available, including Growth Shares; Company Share Options Scheme (CSOP); Joint Share Ownership Plan (JSOP), and Seedlegals’ Unapproved share option scheme, although none of these are as tax-efficient for your employees as EMI.
You have a number of choices when it comes to deciding when your employees will be able to exercise their options (the vesting schedule). Two are exit-only and milestone-based approaches, but time-based vesting is the most popular approach among UK startups.
Time-based vesting means employees can exercise increasingly more options the longer they stay with the company, typically over a three-to-four-year period.
Advantage
This is a good way of ensuring staff stay with you for the long run, while being fair to the fact that sometimes people have reasons why they need to move on sooner than you’d like them to.
Disadvantage
A slight downside to this approach is that staff who started at different times may want to exercise their options at different times, leading to an administrative burden on the company. A way around this is to specify time windows during the year during which this can take place.
For most startups, time-based vesting works best.
Some find that additionally specifying performance-based milestones that allow staff to exercise their options early if they achieve stellar output, can be a really useful way of aligning employee and employer goals.
If a member of staff leaves early under an exit-only scheme, they get nothing. But the situation is more complicated with milestone or time-based schemes. They’ll generally keep their vested shares but lose the right to any unexercised options.
There may also be provisions for what a ‘good leaver’ gets versus a ‘bad leaver’ — and that would typically need to be determined by the company’s board of directors.
If an employee is on a four-year vesting schedule but the company is acquired after two years, companies can specify that all unvested shares are automatically vested upon the exit.
However, this may include a lock-in to ensure the employees stay with the company’s new owners for a specified period (often one year) before they can cash out. This ensures there isn’t a mass exodus of employees after the new owner takes over.
C Leadership - Salary / Equity Breakdown
From our experience adding and including options schemes to employees are a great recruitment and retention options for any startups. Typically, a good benchmark salary for a C-level leadership role depends on the stage and funding.
Salaries are lower at early-stage startups than later-stage scaleups, with early-stage startup employees seeing higher stock options or shares as a counterbalance to their lower salary.
Series B - C
Basic salary: £100K to £150K
Bonus: 20% 30% of basic salary
0.1% to 1.0% of agreed stock option
Seed - Series A
Basic salary: £100K to £120K
Bonus: 10%-20% of basic salary
1.0% to 2.5% of agreed stock options or shares.
Further reading / references / links -
OptionPlan.com; Fred Wilson’s methodology, and Wealthfront’s framework.
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About Santa Monica Talent - We’ve helped more than 50 tech start-ups to scale up since 2015 – building brilliant sales, marketing, software, and leadership teams in the process.