Shares vs options: what’s the difference?
Most UK startups offer equity compensation in the form of options or shares.
What’s the difference between shares and options?
The fundamental difference between shares and options comes down to timing. Someone who purchases shares becomes a shareholder and an investor in the company immediately.?Buying?these shares often comes with certain rights, like voting rights and dividends – when these are given along with the share.
Granting?someone options gives them the right to buy shares in the future, but they don’t become a shareholder – or get any rights associated with the shares – until they actually own the shares.
So far, it sounds simple. Let’s break down what the differences are between shares and options across the following three categories:
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Shares vs options: what’s the difference in payment?
Another critical difference between shares and options is how they are purchased. This difference impacts both the person receiving equity and the company granting it. So it’s important to think carefully about which form of equity compensation to use to avoid problems down the line.
When do employees pay for shares?
When shares are granted as part of an employment contract, they are often issued at nominal value – for example, at ￡0.01 per share, or more. If shares are issued at nominal value, the employee spends next to nothing for their shares, and they won’t need to pay any more in the future.
This is different to a funding round – usually when investors purchase shares as part of a funding round, a premium is added to the nominal value.
When do employees pay for options?
No money changes hands when options are granted or vested. Instead, the option holder pays the strike price when they choose to exercise their options and convert them into shares. The strike price is usually a discount on the fair market value (if it’s an HMRC-approved EMI valuation) at the time the options were granted. The fair market value is based on the price per share that investors paid in the most recent funding round.
In some cases, the strike price can be below market value – even as low as the nominal value.
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Shares vs options: how do shares and options vest?
Vesting refers to the period of time over which shares and options are ‘earned’. The holder only fully owns the equity (shares or options) after this period of time has passed.
What if employees decide to leave the company before the end of vesting period?
Company shares: what is reverse vesting?
Shares are issued and allotted to a shareholder upfront. If the shareholder leaves the company before the end of the vesting period, they will be forced to sell the unvested shares back to the company – usually at nominal or nil value.
It’s common to see startup founders on a reverse vesting schedule for their shares. It helps avoid a situation where a major shareholder suddenly leaves the company and takes a large stake of equity with them. This can make the company uninvestable.
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Whether the employee is a good leaver or a bad leaver?
Good leavers
The idea of a good leaver clause is to reward a key employee for staying employed in the company for a certain amount of time, or until a goal is achieved.
Unlike under incentives such as an option to buy shares, or a clause that vests shares, the person is already a shareholder with the benefits that ownership confers.
The reward is the unconditional continuation of ownership after the occurrence of an event, or retained ownership if the employee leaves the company beforehand but under “good” circumstances.
Bad leavers
A bad leaver clause also aims to incentivise an employee from leaving employment, and also from acting in a 'bad'” way. The incentive is one of loss avoidance – generally a more powerful psychological incentive than reward.
If the employee leaves or is dismissed, he or she forfeits the shares.
A young company is unlikely to be highly valued, yet is likely to have key people employed within it. If the work that the key people do increases the value of the company over time, then the closer to the event that an employee-shareholder leaves, the greater the value at stake to lose by leaving.
A bad leaver clause may penalise the shareholder by forcing a sale at a discount to the current valuation. This may not be sufficient to compensate other shareholders for losses caused by the departing shareholder. Nor may it be possible to pursue the leaver for further damages.
Bad leaver clauses are not an insurance device for other shareholders. They exist to incentivise good behaviour by defining what is bad.
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Shares vs options: what are the tax implications and benefits?
This can seem complex, but the basic principles of the tax strategies are actually quite straightforward. When in doubt, consult a tax advisor.
When are company shares taxed?
Generally speaking, issuing and allotting shares to an individual at a discount will result in an immediate tax payment for both the employee and employer.
To assess the market value of the shares, HMRC either uses the price paid per share by investors in the last funding round or the earning per share according to the company’s trading history. The shareholder is taxed on the difference between the market value and the nominal value the shareholder paid. This difference counts as income and will be taxed as employment income. National Insurance contributions might also be due (NICs).
How are share options taxed?
No tax is paid by either the option holder or the company when options are granted or vested. But when the options are exercised, the option holder will pay Income Tax and NICs on the difference in price between the strike price and the actual market value of the shares at that time. When they sell the shares, the employee is also liable to pay Capital Gains Tax on the profit (CGT).
Is it better to grant shares or share options?
In most circumstances, it is recommend that you set up a share options scheme when you want to reward your employees with equity. There are various tax advantages when you use an EMI scheme, and a scheme allows for flexibility in setting terms around vesting and exercise.
You might have heard that setting up an employee options scheme is expensive, difficult and time-consuming however, it’s simple to create the documents you need in a couple of clicks and manage your scheme online yourself.
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