Last week's ESS webinar was packed with practical takeaways for companies looking to introduce, or improve, their employee share schemes. The event was split into two tracks: EMI schemes with Jerry Davison, and after EMI with Ian Shaw.
This post summarises track one. Many thanks to Jerry Davison for taking part, and Capdesk CEO Christian Gabriel for hosting.
An introduction to EMI schemes
Introduced in 2000 by Labour Chancellor Gordon Brown, the EMI scheme is arguably the best share option scheme in the UK, and one of the best in the world. It’s the default way to manage employee share options for UK companies with fewer than 250 employees.
A share option is a way of giving an employee the chance to buy shares at a fixed price at some point in the future. The employee has a risk-free right to buy those shares, hence they are called ‘options’.
For example, you give an employee options priced at £1 per share, and the right to purchase those shares in three years’ time. When three years are up, the employee can buy those shares, still priced at £1, even if they’re then worth £50 each.
An EMI scheme benefits the employee at the point where they convert their options into shares, because they are required to pay tax on those shares.
Without EMI, the employee pays income tax on the difference between the fixed price (£1) and the market value (£50).
With EMI, the employee pays no tax when buying the shares for £1 each, and then only Capital Gains Tax capped at 10% when those shares are sold by the employee, usually on a sale of the company.
Communicating the advantages of an EMI scheme to your shareholders and employees
What to tell your shareholders:
“Granting shares to employees dilutes the value of existing investors’ shares – in the short term. But an EMI scheme is an investment in the people who work there, arguably your company’s greatest asset. Employees are responsible for generating and building value ahead of a big exit, and a good investor understands that they will be far better off if employees are well incentivised.”
What to tell your employees:
“This scheme is a tax-advantaged way for us to reward your work and recognise your contribution to the company’s growth. We hope in five years when we sell the company you’ll be able to make an attractive sum of money, and only pay 10% tax.”
There are non-financial benefits for both parties as well. Share schemes align the interests of employees and shareholders, which means everybody invested in the business has a common goal.
Which employees qualify for EMI schemes
EMI schemes are for employees only, and employees must work 25 hours per week to qualify. Alternatively, employees must dedicate more than three-quarters of their total paid working week to your business.
EMI vesting schedules: exit-only vs time-based
The two most common EMI structures are exit-only and time-based.
In an exit-only structure, employees:
- Can only buy their shares when the company is sold or traded publicly
- Tend to exercise their options in order to sell them right away
- Focus on building up company value towards a sale
- Cannot become shareholders before a sale
- Have a vesting schedule, typically spread over four years
- Can exercise options gradually over the vesting period
- Can become employee shareholders before an exit
- Tend not to buy shares until an exit event anyway (unless there will be dividends paid on the shares)
Bigger companies might combine the two structures, offering exit-only share plans to the majority of employees, and time-based share plans to senior management hires.
HMRC and company valuations
Submitting a valuation proposal to HMRC is an important component of setting up an EMI scheme.
The valuation fixes the value of a share in relation to the company’s overall market value. When it comes to selling those shares in future – and paying tax on the difference – this matters a lot.
To determine the correct valuation, review any outside investment from the past 24 months. Working from the price per share in that investment, you can make deductions for:
- Any tax advantages that investors received, such as EIS (Enterprise Investment Scheme) tax relief
- Investor perks such as a seat on the board
- Liquidation preferences on the investors’ shares
All of these factors allow you to downgrade the employee share price and get a better deal for employees, fixing the tax they pay at a lower rate.
In the absence of recent investment, you would normally look at the last few years’ profit history to determine a valuation, using a multiple of earnings calculation such as p/e ratios.
Once HMRC approves your valuation, you have 120 days to grant options at the agreed value. However, if you raise £10 million 30 days into that period, your valuation is invalidated – that’s something you have to disclose.
Not what you were looking for? Read our blog post on track two with Ian Shaw to learn about employee shares schemes after EMI.
Want to know more? Reach out to us and we'll connect you with either Jerry Davison or Ian Shaw.