Incentivising your workforce: EMI schemes
There are clearly all sorts of variables that come into play here. In this article we look at just one option: giving the employee a right of ownership. This can be achieved by the transfer of shares from one person to another, but given that there are several HMRC approved, tax efficient schemes, it seems sensible to explore alternatives.
For smaller (generally owner-managed) and often high risk, trading companies, an EMI scheme is a popular choice.
How EMI schemes work
The basic structure is simple. The grantor company gives the employee the right to acquire shares at some point in the future. Both the exercise price and the maximum number of shares over which the option can be exercised are fixed at this point. This is known as the date of grant. Exercise of the option can then be subject to bespoke performance or vesting conditions. Instead or as well as a performance or vesting condition, it can be structured so that it is only exercisable on an exit (whether that is a trade sale, equity investment or a listing). The employee pays nothing to receive their option but then pays an exercise price when they "exercise" it which is the point at which they become a shareholder. The tax break is that provided the exercise price, which is set at the date of grant is the then current market value, the gain on any subsequent sale will be in the capital gains tax regime (with all the relevant reliefs available) rather than the income tax one. Furthermore, provided conditions are met, the holding of the option counts towards the qualifying period for entrepreneur’s relief to apply.
The key documents are a set of option rules and then a bespoke offer letter for each option holder. Subject to the requirements of any existing shareholders' agreement, setting up the scheme does not generally require shareholder approval. However the grant of a right to acquire shares (which is what an option is) does. It requires shareholders to give the directors authority both to grant the right and to do so without reference to any applicable statutory or constitutional rights of pre-emption.
Exercise at the end of a performance or vesting period
In this structure, an option holder is given the right to acquire a maximum number of shares at some point in the future. There is no minimum holding period. This structure is commonly used where the company anticipates being in a position to pay dividends and wants to reward, retain or recruit staff by doing so. Arrangements can be bespoke for each option holder: for example, a long standing staff member can be given the right to exercise earlier than a new recruit. An important factor to remember here is that because the option holder will become and continue as a shareholder, the employer needs to consider what structure needs to be in place should s/he leave or at some future point, the company receive a third party offer. Following exercise of the option, the relationship is governed by the articles of association of the company, not the option rules.
Exit only options
These are commonly used when employers have a strategy for growth aiming for a view to a sale in say three to five years. Exit only options provide a mechanism for employees to share in that growth. In this structure, the option holder is given the right to exercise immediately before the third party sale. If structured correctly, the employee does not have to supply funds (the exercise price) in advance, this can be taken from the sale proceeds. He is only a shareholder for a millisecond. This way, the company does not have the administrative burden of additional shareholders in the medium term and there is no risk to the option holder of paying for shares without knowing whether they can be sold. The ideal time to set this sort of option up is right at the start of the journey when the share price is at its lowest.
Qualification and statutory requirements
EMIs are not suitable for every company. To qualify the company must be an independent trading company with:
- gross assets of no more than £30 million; and
- fewer than the equivalent of 250 full-time employees.
This means that where there is a group, options can only be granted over shares in the top holding company.
EMI options can only be grated over fully paid up, ordinary shares.
To be eligible, an employee must work for the company for at least 25 hours per week or if less, 75% of their working time. HMRC has issued clarification regarding how this translates to employees on furlough. EMI options cannot be grated to non-executive directors or consultants.
Employees cannot be granted EMI options if they or their "associates" have a "material" interest in the company whose shares are used for the scheme.
Employees can only hold unexercised EMI options over shares worth up to the current EMI individual limit (currently £250,000). A company cannot grant EMI options over more than £3 million worth of shares at any one time.
Options must be capable of being exercised within ten years of the date of grant and can only be exercised within a period of 12 months of the option holder’s death. The option rules will commonly provide that they lapse on cessation of employment (although early exercise may be permitted in some circumstances).