Share options were a popular form of remuneration in the 1990s. More recently, however, they fell out of favour because neither of the two conditions that make them an effective form of pay – increasing share prices or if companies are being bought or floated (Initial Purchase Offer) on the stock market – had been occurring to any extent of late.
However, change is again on the horizon. The stock market is looking healthier, and corporates are beginning to do deals. As a result, share options are making a comeback, particularly in the technology sector, and US companies are rolling out their stock option plans to employees around the globe.
Here are key issues to consider in relation to share options:
1. What is a share option?
A person who has a share option does not own the share itself. The option gives the holder the right to acquire a share in certain circumstances and at a certain price (the exercise price). The exercise price might be the market value of the shares on the date of option grant, or be a fairly nominal amount. Share options can be a tax-efficient way of remunerating employees.
2. Why bother?
Share options can be a very good way of allowing employees to feel like they are stakeholders in, or owners of, their employer. They can also help employees focus on a shared corporate goal – like a trade sale or an IPO.
However, for options to have their desired goal, the company should first decide its objectives for introducing the plan. It should clearly communicate the objectives to employees, as share options are not the easiest concept to understand. If the options are to incentivise and retain employees, the employees must understand how they can get value out of the options.
Listed companies generally introduce share option plans that are open to all of their employees worldwide, as it helps employees feel part of the global entity.
As employees can sell the shares on the stock market once they exercise the options, the purpose is usually to allow employees to share in (and focus upon achieving) an increase in share value. It also acts as a retention tool as employees generally sacrifice unvested options if they resign.
Private companies do not have a ready market for their shares. They do not generally want their employees (other than perhaps senior executives) to own actual shares in the company. Therefore, companies that hope to IPO (or undergo a merger) grant share options that are only exercisable on an IPO. This focuses employees on achieving the IPO. It also acts as a retention tool, locking in talent until the IPO.
3. Different types of share option plan
There are basically three types of popular share option plan. These are the Approved Company Share Option Plan (CSOP); the Enterprise Management Incentive Plan (EMI); and the unapproved plan.
This is an Inland Revenue approved plan. Options can only be granted under a CSOP if the Inland Revenue has first approved the plan. The plan has to meet various Inland Revenue criteria.
They are not necessarily difficult criteria to meet, but the plan cannot be as flexible as some companies would like. The options can be over a US parent company and it is possible to introduce an Inland Revenue approved ‘sub-plan’ to an existing US stock option plan.
The main benefit of a CSOP is the employee does not incur income tax on grant or exercise of the option. The exercise price must be no less than the market value of the shares at the date of grant. An employee can hold options over shares worth up to £30,000 (valued at date of grant).
When the employee sells the shares, they will face a CGT charge on the difference between the exercise price and the ultimate sale price. However, if the employee has owned the shares for two years or more, the effective CGT rate may be as low as 10 per cent.
(b) EMI options
EMI options are probably the most tax efficient type of option. However, as they are designed for small but fast-growing companies (including US parent companies with the UK employees), there are a number of criteria that the company must meet before it can have an EMI plan.
For example, the company (or the whole group) must not have gross assets worth more than £30m. If it meets all of the criteria, an eligible employee can hold options over shares worth up to £100,000 (valued at date of grant of the option). The tax treatment is similar to a CSOP option, with one major exception.
On sale of the shares, capital gains tax is due. However, if the employee sells the shares more than two years after being granted the option (and not exercise of the option, as with the CSOP), the effective CGT rate could be as low as 10 per cent.
(c) Unapproved options
Very flexible plans: most options granted to UK employees under US stock option plans will be treated as unapproved options. Nothing special has to be done to grant the options and as a result it is very simple to issue the options to UK employees.
No special tax treatment is afforded to this type of option. There is no tax on grant but there is an income tax charge on exercise of the options. The tax is due on the difference between the market value of the shares on date of exercise and the exercise price paid.
There will also be National Insurance Contributions (NICs) due on the same amount. Therefore, before an employee exercises an unapproved option, it is crucial they can immediately sell sufficient of the option shares acquired to realise enough cash to pay the tax.
4. National Insurance Contributions
NICs will be due on the same amount that is charged to income tax. Employers’ NICs are charged at 12.8 per cent and this can be very expensive for the company. It is an unknown liability as NICs are due on the increase in share price, which is hard to predict. This causes a particular headache for US companies as it creates a ‘variable accounting’ charge – something that all US companies strive to avoid.
It is now possible to pass on the liability for employers’ NICs arising in respect of share options (and other forms of share based compensation) to the employee. The best way to achieve this is by entering into a ‘joint election’. The joint election has to be a separate document and in a form agreed with the Inland Revenue, however once in place should remove the ‘variable accounting’ issues in the US.
5. What to look for in an option plan
There are a number of different ways in which options might vest (ie. become exercisable). If the plan is a CSOP, or the purpose of the plan is to retain employees, the options will usually have to be held for 36 months before exercise. If the purpose of the plan is to incentivise the employees to achieve specific corporate goals, then the options will only be exercisable once the performance conditions have been met.
(b) Exercise price
Most share options have an exercise price in which case even if they have vested, an employee will not bother to exercise them unless the current value of the shares has climbed above the exercise price.
Options will usually lapse on, or within a short period of time after, an employee leaves his job.
If an employee is a ‘bad leaver’ then the option will usually lapse immediately. If the employee is a ‘good leaver’ then he may have a period of time to exercise the options – often six months. It is therefore important to define when an employee will be a good leaver. Good leavers are usually employees dismissed for redundancy or sickness or who retire.
(d) Change of control
It is important that the option holders are treated fairly on a change of control, but at the same time the change of control provisions should give the directors as many ways as possible of dealing with the options. If the acquiring company is US-based it may want to ‘adopt’ the plan rather than have the employees exercise the options. Therefore, the plan should allow options to be ‘rolled over’ into options over shares in the acquiring company. Alternatively, it may be important that the options are exercised so the acquirer can purchase the shares under option.
Used properly, options can be a very effective way to incentive and retain employees. It is fairly simple to roll out US stock option plans to employees based in the UK and the rest of Europe, although it is harder to obtain local tax breaks without quite a lot of work.
Stephen Brown is partner and head of the employment and benefits team at Latham and Watkins