How do employee option schemes work?

Employee option schemes are designed to allow employees to share in the value of the company’s future growth. This post explains how they work.

Overview

The key elements of an employee option scheme are:

1. The company issues options to participating employees.
2. The options give participants the right to buy shares in the company at a specified exercise price.
3. There are normally conditions that must be satisfied before an option can be exercised, such as performance targets or the lapsing of a specified period of time (known as a ‘vesting period’).
4. There are usually restrictions on a participant’s ability to sell options or shares acquired under the scheme.
5. Options are typically forfeited if a participant leaves the company during the vesting period.

Each of these elements is explained in more detail below.  (You can read more about other types of employee share schemes here.)

1. The company issues options to participating employees

Options are normally issued to participants upfront, rather than in tranches, for no or nominal consideration.

Options are usually issued upfront because this will usually provide a greater incentive (and financial reward) for a participant than would be the case if they were issued in tranches over time.

Participants are not usually required to pay any amount (or at least not any significant amount) to receive their options under the scheme.

2. The options give participants the right to buy shares in the company at a specified exercise price.

The exercise price is specified at the time the options are issued. The price is normally set at a value that is no less than the company’s market value at the time of issue. This is to ensure that participants are not required to pay any tax at the time they join the scheme.

Many companies will seek a formal valuation, or at a minimum seek advice from their accountant, before setting the exercise price.

The requirement for participants to pay an exercise price has several important consequences.

First, it means that participants only receive the opportunity to share in the value of any growth in the company that occurs after the time the options are issued.

Second, it means that the existing shareholders are not ‘giving away’ any existing value. All they are doing is giving away the opportunity to share in future upside, on the assumption that the participants in the scheme will be in a position to help drive future growth.

In many instances, participants are never actually required to pay the exercise price from their own resources.  For example, if there is a liquidity event (such as a trade sale) or if the participant leaves the company, the participant’s vested options might be cancelled or they might be exercised, and converted into shares, and then sold.  In either case, for each vested option, the participant would receive the difference between the exercise price and the value of a share in the company at the time of the cancellation or sale.

3. There are conditions that must be satisfied before an option can be exercised.

There would normally be constraints on a participant’s ability to exercise an option acquired under an employee share scheme.

Vesting Periods

Sometimes, this is simply the expiry of a vesting period. For example, the scheme rules might say that there is a 3 year vesting period in respect of an option, and that options cannot be exercised until the vesting period has expired. This means that the employees will effectively have to earn their entitlements under the scheme.  Read more about vesting periods in ESOPs here. 

Performance Targets

In other cases, the company may impose performance targets. For example, the scheme rules might specify certain performance targets (for example, EBIDTA targets), and contain a formula that explains how the number of options that will vest will depend on the company's performance relative to those targets.

Any performance targets should be objective, and capable of relatively easily calculation. Otherwise this can make the scheme less attractive from the perspective of the employees.

The targets can be company-based targets (such as EBIDTA), they can be specific to individual employees (such as KPIs), or they can be a combination. The actual performance targets incorporated into any option scheme will always be specific to the company concerned.

Liquidity Events

Independently of vesting periods and performance targets, some option schemes will prevent participants from exercising their options until there is a liquidity event, such as a trade sale or listing.

This type of arrangement is most common where the company’s shareholders have clear ambitions to sell the company in the short to medium term, and where the main benefit for participants is intended to be in the form of a capital return (as opposed to the opportunity to participate in future dividends).

4. There are usually restrictions on a participant’s ability to sell options or shares acquired under the scheme.

This rule is intended to serve two purposes.

First, most shareholders of private companies wish to keep tight control over their share register, and do not want employees selling their options or shares to other shareholders, let alone strangers.

Second, if there are no restrictions on a participant’s ability to sell their options or shares, this can prevent the employee from qualifying from certain tax concessions – the value of which can be significant.  Read more about the tax issues that apply to employee option schemes here. 

5. Options are typically forfeited if a participant leaves the company during the vesting period.

If an employee leaves the company during the vesting period, their options would typically be forfeited. Again, the intention is to incentivise participants to remain valuable employees for at least the medium term.

Some schemes will contain exceptions to this type of automatic forfeiture – for example, where the participant is deemed a ‘good leaver’ (for example, if they are forced to leave as a result of serious illness or incapacity), or whether the board decides, in its absolute discretion, that the automatic forfeiture should not apply.

Other Considerations

Any employee option scheme should be designed to take into account the circumstances and commercial objectives of the specific company concerned. In addition, tax considerations will play an important role in the design of any scheme particularly the availability of the start-up tax concession. 

The purpose of this article is simply to highlight some of the more common features of employee option schemes. If you would like to know more, you can read about how employee share schemes or ESOPs work here.