When recruiting into fast growing technology companies, equity participation is an established and expected benefit.  These companies are built with a liquidity transaction in mind and tax approved equity incentives can align employees with the interests of founders and investors. Where employees feel a sense of "ownership" this can bring enormous benefits to the company. However when employees move on, we're seeing the establishment of share incentives collected at each company building the foundations of a personal investment portfolio where they have invested their time and expertise, rather than money. This trend sparks a conversation about the best way to structure share incentives from the outset.

The success of the tech ecosystem in Scotland has created unprecedented demand for talent and this demand, along with informed, educated and mobile individuals who have experienced equity incentives in previous successful exits, is leading to a change in how share incentives are structured.

The tax approved Enterprise Management Incentive (EMI) scheme allows for significant flexibility in terms of how an individual’s share incentive package can be structured; with the key ingredients being the number of share options, the exercise price, the period over which the options will vest, the performance conditions attached to the vesting and the circumstances in which an option can be exercised.

A key consideration is what happens to the share options if someone leaves before they are exerciseable and this is where the forces of change are becoming evident.

Previously, it would be typical for share options to have a defined vesting period, performance conditions (typically continued employment at set dates) and a right to exercise on a liquidity event (sale/flotation).  If the individual left prior to the liquidity event, the options would typically lapse which would allow those options to be recirculated to other employees (perhaps their replacement) or simply not allocated in which case the dilution for founders/investors/option holders is less.

Increasingly, it is becoming the new normal to allow leavers to retain the right to exercise any options that had vested prior to their departure.  This can clearly be viewed as equitable because if an individual has contributed to the growth and success of the company over the vesting period, why shouldn’t they retain that right?

It does however present potential challenges.  Firstly, the company may need to grant options to anyone who replaces the leaver, which could lead to increased dilution that would not have been anticipated at the outset. Secondly, is considering how it may change the behaviour of employees and whether it could create a portfolio-building type approach.

How might this work in reality?

The typical vesting period that we see for options is three years. As an example, an individual is granted options over 3,000 shares and they vest at 1,000 shares per annum. The time horizon for start-up, to scale-up, to exit is generally much longer and can be around 5-10 years.

The employee has achieved their full entitlement after 3 years. If the expected time horizon to exit is still several years out, they could, in a competitive ecosystem where opportunities are plenty, take the view that leaving to join another business in which they are offered share incentives is a wise move. Over the typical exit time horizon, they could move 2-3 times allowing them to achieve equity participation in 3-4 companies - essentially a portfolio approach akin to investors.

Clearly an individual will have several things to consider beyond equity incentives before moving employment, but in an ecosystem that is increasingly spawning propositions, this is a real option for many people and a new element to the retention challenge faced by employers.

To my mind, what this means is that equity incentives need to be considered very carefully. There is generally a desire to spread equity incentives across an entire team so that everyone benefits to a lesser or greater extent. For those individuals with relatively modest incentives it may be less of an issue, but where an individual is critical to the success of the company, then structuring their options such that they are incentivised for the duration of the journey may be advantageous.

It would also be important to note that share options are only part of the recipe for building successful teams.  Our experience of successful entrepreneurs is that they have had a razor like focus on their recruitment, investing resources to make it a mission critical process and then developing effective processes to manage, develop and retain their talented people.

Next steps:

To discuss the changing nature of incentivisation and the key considerations around EMI schemes please get in touch with me, or a member of our Entrepreneurial Taxes or Technology & Life Sciences teams.