Share options granted by a company give the holder the right to buy shares from that company at some date in the future. Companies will often grant options to employees as part of their overall remuneration package as a way to motivate them and align their interests with those of the company’s shareholders.
The holder of the options has no voting rights or rights to dividends in respect of the options. Only when the shares have been bought will the holder have the voting and dividend rights attaching to those shares.
The options just give the holder the right to decide whether to take up the options and, therefore, the holder is not forced to buy the shares if they do not want to.
The price at which the shares are to be bought, often called the exercise price, is usually set when the options are granted. The option holder will, therefore, when looking to exercise the options to buy the shares compare the exercise price to the then current market value to see if it is worth exercising the options.
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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.
There may, however, be certain criteria that need to be met before the option holder can exercise their options. Indeed, 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.
Such options will often also have an expiry date when they must be exercised by or they lapse. This is especially the case under the various tax advantaged schemes.
Setting up a share option scheme
The first step before granting options is for the company to get approval for the share option scheme from the shareholders, as any shares issued by the company on exercise of the options will dilute the existing shareholders’ interests in the company. Indeed existing shareholders will often have pre-emption rights when new shares are issued. The shareholders will need to approve the terms of the options to be granted.
The terms may just be set out in an agreement between the company and the option holder when the options are granted. Such an agreement would also set out the number of options, exercise price and period when exercisable. Alternatively, the share option scheme may be set up as a formal share option scheme with its own rules, as required for options granted under the Enterprise Management Incentive (EMI) scheme. 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 a tax advantaged scheme, or employees, including directors, of the company.
Types of share option scheme
There are a number of share option schemes available to employees of the company that provide tax breaks when the options are exercised.
The main schemes offering tax incentives available for employees are:
- Enterprise Management Incentives (EMIs) – available to companies not carrying out excluded activities with gross assets of less than £30 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
In addition, companies may set up unapproved share option schemes for employees but these will provide no tax breaks to employees. Companies can also grant share options to investors that are not employees of the company.
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. The shareholder approval will cover:
- The number of options granted to each person;
- The exercise price per share that the option holder will need to pay;
- The date that the options are first exercisable by the option holder;
- Any other restrictions on when the options can be exercised;
- The date, if any, that the options expire; 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.
Where a formal share option scheme has been set up, then 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.
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A company has three senior managers that it wants to remunerate based on the work carried out over the last three years but is not in a position to pay them any more. The company decides to set up an EMI share option scheme and grant options to purchase ordinary £1 shares at the current market value of £1.50 per share to them as follows:
- Annabel – 1,000 shares
- Duncan – 500 shares
- Shirley – 1,500 shares
The EMI scheme is approved by the shareholders as are the awards of the different options. The three managers will then be able to exercise these options after at least three years and must do so within ten years. The hope of the company and the employees is that the share price will be significantly more than the exercise price of £1.50 per share when the options are exercised.
Exercising share options
When the option holder decides to exercise their rights under the scheme, they need to inform the company that they are exercising their options and pay the exercise price to the company. There may be an exercise options form issued to the holder by the company when the options were granted. Alternatively, the option holder should send a letter or email to the company stating that they are exercising their options to buy shares.
The option holder would also need to send a cheque or make an electronic transfer to the company’s bank account for the full exercise price.
The company will then meet the exercise by:
- Allotting new shares to the option holder;
- Transferring shares out of treasury; or
- A combination of these.
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 payable. If PAYE was not payable, then any gain over the exercise price is payable even where this was less than the market value at the date of exercise.