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In the start-up world, share options have become a popular “buzz term”. However, there is still some confusion about what they actually are, and what benefits they confer on both the company and the individual option holders. For start-ups and SMEs, equity can be a great way to attract, incentivise and align goals with key employees or directors, while preserving precious cash reserves.

When actual shares (as opposed to share options) are transferred or issued to employees, those individuals become the legal owner of shares in your company and are therefore listed as shareholders on your company’s register of members. Depending on the rights attached to the class of share they get, recipients could then immediately become entitled to certain shareholder rights, including dividends from historic and future profits, voting rights and proceeds from the sale of the business or its shares. Note that the granting of shares may also give rise to an immediate tax charge for the individual.

Directors could also offer equity to its staff via the establishment of a share option scheme. Share options confer on the option holder a right (but not the obligation) to acquire a set number of shares at a fixed price at some point in the future. Where it differs to the transfer/issue of shares is that the option holder is not automatically a shareholder of the company, but could become one when they eventually exercise their options.

Broadly speaking there are two types of share option schemes that are most common amongst SMEs: Enterprise Management Incentive (“EMI”) Schemes, and Unapproved Share Option Schemes. EMI schemes are usually the more attractive option for new and growing businesses, as they are a tax-advantaged scheme and can benefit both the company and the option holder. However, EMI options aren’t available to all; a start-up and the proposed option holders will need to meet certain criteria for HMRC to approve the scheme.

When choosing between the various options discussed above, there are a number of matters for directors to consider:

Tax – what impact will the scheme have on the company and employee? EMI share option schemes are generally much more beneficial for both in this respect.
Valuation – ultimately the value of the options or shares is determined by the company. However, HMRC will check that income tax and NICs are not being unduly avoided.
Flexibility – if your employee/consultant leaves on bad terms, what would you like to see happen to the shares or options? (The lapse of options is usually simpler than trying to clawback shares) And what if they leave on good terms?
Income or capital – is the greater future value in receiving dividends from profits (shares may be best) or in a capital gain following, for example, an IPO or business sale (exit-only options may be best)?
Timing – when should the individual be able to own the shares? i.e. what vesting and exercise conditions should you attach to the options

However, directors should not rush to hand out equity to their employees. There are other ways to incentivise your staff, such as offering commission-based bonuses to marketing or sales team members or other innovative office perks, and if there’s a way to hold on to as much of your company as possible, that is certainly something worth considering.

Regardless of whether you decide that the grant of shares or share options is best for your team, it is crucial that the terms applicable to each are properly documented. It can be much more difficult to claw back shares, or lapse options when detailed vesting or leaver provisions have not been set out in writing.

Caroline Sherrington is senior counsel at Ignition Law.