This article first appeared in Digit on 2 June 2022.

One of the most popular tools for technology start-up and high-growth firms to attract and retain talent is employee share options.

Historically, share options might have been used by start-ups to compensate for a reduced salary but against a backdrop of a scarcity of talent and cost inflation, equity participation is now more typically the cherry on top of a competitive salary and benefits package. Equity participation has become an expected benefit of working in a start-up/scale-up environment and the structure needs to be carefully considered to ensure that they do indeed retain talent and help the company achieve its objectives.

Enterprise Management Incentive (EMI) schemes provide key support for fast-growth, entrepreneurial companies to recruit and retain the best talent. They allow qualifying employees to acquire shares at a fixed price, agreed at grant date, and to accrue benefit through future growth in the company’s value.

A key point is that employees need to understand the potential value of their option award. Many employees won’t understand the agreement if it’s not explained properly, and if they do not understand the value, the incentives will not act as a retention tool. Founders therefore need to understand the EMI scheme so they can clearly articulate the value to their teams. Clarity of communication and messaging is critical and if the company has employees who have previously enjoyed a successful equity incentive, they can act as ‘ambassadors’ to the wider employee group.

Many high-growth companies looking to sell within five to ten years have an EMI share option plan in place, and when these types of plans work well, they can drive fantastic results.

But care needs to be taken. During due diligence at an exit event, the solicitors acting for a purchaser will take a keen interest in employee share incentives and this can lead to unforeseen outcomes.

Some of the potential pitfalls with an EMI scheme, and the focus of this article, relate to companies that are built around an exit-only plan, as is increasingly the case.

On a basic level, let’s say that a company is looking to sell in five years and grants an individual EMI share options over 5 years, which vest (or are ‘earned’) one per year. Depending on the leaver terms, if the staff member only stays at the company for two years, then they are entitled to two shares, and if the employee passes five years’ service, they are entitled to all five.  

But what if a company gets an offer it can’t refuse in year three?

The original intention from the founders might be for that employee to get five years’ worth of EMI shares, and the employee may have joined the company on that basis. This is commonly known as “accelerated vesting on an exit”. But the legal agreement, depending on how it is drafted, might only entitle them to the shares they earned for the two years they completed at the business before it was sold, despite the intention being otherwise.

That is why the wording of the agreements that underpin such a scheme are vital in terms of keeping all parties right.

Businesses might find they are left with an option plan that isn’t delivering what they had planned. Firms are prevented from amending that option agreement under EMI provisions. If they were to try that, the shares could lose all their tax advantages, as this could be considered a material improvement to the share options.

It is therefore key that companies work closely from an early stage with specialist legal and tax advisers who have deep knowledge and experience of share incentives, and can lead them through a range of areas from understanding vesting terms, ensuring that working time requirements are signed off, and drafting appropriate plan rules and option agreements that are tailored to their exact requirements. Working with the right advisers at this stage should allow for a far smoother process when it comes to exercise/exit events.  

Where we see problems is where an inexperienced adviser has acted on an ‘execution only’ basis. The scheme has been set up based on the company’s instructions, but an adviser needs to bring insight and experience where they can challenge instructions and help the company implement a solution that is not just compliant but is fit for purpose for the future.

A business may be sold ahead of schedule and options may still be vesting. Staff who are option holders are expecting a certain payment, and then find out they aren’t getting what they expected, which can create obvious problems. As mentioned above, clarity of communication and understanding of the scheme rules is critical.

With Mergers & Acquisitions (M&A) activity continuing to surge, many tech and high growth companies are being sold just now. In a company sale, due diligence will include checking the company’s EMI plan. A buyer will broadly be looking to see that the scheme is set up properly, is bona fide and doesn’t give any other cause for concern. A non-compliant scheme can disrupt an exit and increase tax costs for the company and option holder.

For those businesses who are unsure about their EMI scheme, the good news is that there are experts who can advise you on how best to proceed.

It is imperative that firms take steps to ensure they are aware of the potential pitfalls and that they think about what they’re hoping to achieve before putting such a plan in place. My advice would be not to rush in when it comes to setting up such a scheme.

If you choose the right advisers, you should be able to navigate the various stages, and provide a robust outcome that is fit for purpose, which will also see employees well rewarded when that exit comes. If everyone is on the same page, EMI schemes can work for all involved.

Get in touch

If you would like to discuss this further, please do not hesitate to get in touch with myself, a member of our Entrepreneurial Taxes team, or your usual Johnston Carmichael adviser.