Share options: What are they and how do they work?

Share options granted by a company allow the holder to purchase shares at a future date. Companies frequently offer options to employees as part of their compensation package to motivate them and align their interests with shareholders.

Option holders do not initially possess voting rights or rights to dividends in relation to the shares subject to the options. These rights only arise when the shares are purchased on exercising the options.

Importantly, holders have the right to decide whether to exercise their options during the exercise period; they are not forced to purchase the shares.

The exercise price, usually set at the time of granting the options, is the price at which shares can be bought. Before exercising options, holders typically compare this price to the current market value to help decide whether or not to proceed.

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Joan, a senior manager, has options to purchase 100 ordinary £1 shares at an exercise price of £5.00 per share, granted to her when the market value of the shares was £2.50 per share.  The shares need to be exercised shortly or they expire.  She, therefore, sees that the current market value of the shares is around £10 per share which she is happy is more than the exercise price so decides to exercise her options. 

There is no guarantee that she will be able to sell her shares at £10 each or even for more than £5 each.  She may even lose the total amount invested in the shares.

However, certain criteria may need to be met before options can be exercised. Where options are granted to employees, it is common that:

  • the options must be held for a minimum period of time after they have been granted before being exercised; and
  • the option holder must be a current employee at the time of exercise and will lapse when the holder ceases to be an employee.

Options like this will often also have an expiry date. They must be exercised by this date or they will lapse. This is especially the case under the various tax advantaged schemes.

Setting up a share option scheme

Before granting options, the company will need shareholders‘ approval for the share option scheme. Issuing shares upon option exercise will dilute existing shareholders’ interests and so will impact any pre-emption rights. Shareholders will also approve the terms of the options before they are granted.

Options may be detailed in an agreement between the company and the holder. This agreement will specify: the number of options, exercise price, and exercise period. Alternatively, the scheme can be a formal share option scheme, such as under the Enterprise Management Incentive (EMI). In this case the grants can be made over a number of years to the same or different employees.

The terms of the share option scheme will cover items including:

  • the types of person eligible to be granted options under the scheme;
  • whether the options are transferable and if so any restrictions on transfer;
  • if the options are lost on the occurrence of certain events (eg option holder leaving employment, company being taken over, etc);
  • the exercise price, unless the scheme will cover a number of separate grants over time; and
  • the exercise period, unless the scheme will cover a number of separate grants over time.

The share option scheme can be for third-party investors (unless structured as a tax-advantaged scheme) or employees, including directors.

Types of share option scheme

There are several share option schemes a company can use that provide tax incentives to company employees upon exercise:

  • Enterprise Management Incentives (EMIs) – available to companies not carrying out excluded activities with gross assets of less than £60 million and less than 250 employees
  • Company Share Option Plan (CSOP) – available to companies of any size unless they are carrying out certain excluded activities
  • Save As You Earn (SAYE) – available to listed companies and companies not under the control of another company

Additionally, companies can establish unapproved share option schemes for employees without tax benefits. Share options can also be granted to non-employee investors.

Granting share options

Shareholder approval is needed for the options being granted under the scheme. This will often be done when the scheme is approved, especially where the scheme is set up by an agreement with the employee.  Shareholder approval will often cover:

  • Number of options granted to each person;
  • Exercise price per share that each option holder will need to pay;
  • Date that the options are first exercisable by the option holders;
  • Any other restrictions on when the options can be exercised;
  • Date, if any, that the options expire;
  • Any other events that will cause the options to lapse; and
  • Any amount payable by the option holder for the grant of the options – this is only likely where the options are granted to potential investors rather than to employees

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Where a formal share option scheme has been set up, each time new grants are awarded they will normally need to be approved by the shareholders.

When the options are granted the recipient should receive

  • the option agreement or a copy of the option scheme rules;
  • a share option certificate setting out the number of shares and the exercise price; and
  • an exercise options form.

A company wishes to both reward three senior managers for their work over the past three years and to further incentivise them without increasing their pay. They establish an EMI share option scheme and grant options to buy ordinary £1 shares at the current market value of £1.50 per share:

  • Annabel – 1,000 shares
  • Duncan – 500 shares
  • Shirley – 1,500 shares

The shareholders approve the EMI scheme and these specific awards. The managers can exercise their options after at least three years, with a deadline of ten years. Both the company and the managers anticipate the share price will exceed the £1.50 exercise price upon exercise.

Exercising share options

When opting to exercise their options, holders must notify the company and pay the exercise price. They may use an exercise options form issued by the company when either the options were granted or the company informs the holders that the option can be exercised. Alternatively, the option holder should send a letter or email to the company stating that they are exercising their options to buy shares during an applicable exercise period.

Payment is typically made by electronic transfer to the company’s bank account for the full exercise price.

The company will then meet the exercise by:

Tax on exercising options

When an employee exercises options, PAYE and potentially National Insurance (both employee and employer) are payable where the exercise price is less than the current market value, unless the options have been granted under a tax advantaged scheme.

Where PAYE was payable on exercise, when the shares are sold any gain over the market value at the date of exercise or exercise price if higher is subject to tax.  If PAYE was not payable, then any gain over the exercise price is subject to tax even where the exercise price was less than the market value at the date of exercise.

A previous version of this article was published on 12 May 2020.

Inform Direct is the innovative and easy way to manage a company's shareholders and option holders as well as to record option grants and exercise, share allotments and more.

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