- What scheme would you recommend for a new company wanting to issue shares to staff based on some company performance metric in the future?
- Would an EMI options scheme be appropriate with the trigger event being, for instance, turnover of £5m?
- What other options are there?
These were the 3 questions posed by Richard from an engineering consultancy.
And this was the insightful and pragmatic answer from Nick Lawson, one of Tectona’s 15 finance gurus:
The simplest way to reward your people for achieving targets is to pay a bonus or maybe offer an incentive like a holiday. It gives them instant gratification, will be appreciated and is easy to administer. The only downside is the amount of money the tax man will take in PAYE and employer and employee NI.
Enterprise Management Incentives or “EMI” options are a terrific way of bringing employees into the ownership of the business, making them feel valued and more generally aligned to the long term success of the business. Options can be linked to achieving targets, such as beating £5m turnover, so they can bring specific performance focus as well as encourage more general ownership behaviour.
Options only really work if employees can see the potential benefit. If your business is being built up and groomed for a sale, then allowing key employees to have access to a bit of equity is a powerful incentive. If it’s a family business with no ambition to grow and exit, then dividends would be the only benefit to an employee of owning shares. If the options require the staff to pay a significant amount of cash to get hold of their shares, this can be something of a disincentive.
The benefits of EMI options include:
- Long term incentive with ability to create short term performance focus
- Very good tax treatment on any profit made from selling shares acquired – all profit taxed as capital gains (i.e. no PAYE and no NI) and for most employees this will be at the 10% Entrepreneur’s Relief rate
- Employees who leave don’t take option rights with them – unexercised options lapse
- The options price can be heavily discounted (possibly up to 95%) for small employee option grants with no immediate tax consequences. For example an employee could be allowed to acquire a share for £1 that has an open market valuation (were the business to be sold) of £10 – giving an immediate paper profit.
The downsides of EMI options include:
- If no exit is ever planned, options have limited incentive/reward value
- Some staff can have difficulty grasping the value of an option – cash may still be king
- They involve giving equity away – are you prepared to do that? If you are not; ask yourself if your greed might mean you are missing a trick. 10% is a normal option pool size in many businesses
- You may need to revisit your Articles of Association to ensure your capital structure is correct (especially if you regularly pay dividends and may not want to do that for staff shareholders every time)
- It is preferable (though not essential) to get HMRC to approve the option price you are going to grant your options at. That way there cannot be a challenge later that the options were granted at a discount. Any such discount is taxed as a benefit in kind and has the old PAYE and NI consequences.
To sum up – EMI options are a great tool and should be considered very seriously. However, they don’t suit all businesses and you will initially need to engage a professional to help you navigate the legal issues (Articles) and the share valuation and set up. Once a scheme has been established it is much easier and cheaper to make subsequent grants of options. With the help of a Tectona FD, you will be able to do the planning more effectively and so save quite a bit a cash on the valuation and legal structure. This is one area where a DIY approach could turn out to be costly.
Tectona has just launched its free “Ask the FD” service; click here to read other questions asked and the pragmatic answers given.