When you are in the early stages of developing your startup and have not generated any revenue yet, it can become difficult to attract employees. The most common solution is often offering a percentage of your business equity to prospective employees to incentivise them to join your team.
We see many founders grant shares to early-stage employees to bridge this gap between starting out and being able to pay them a salary. Shares are often the go-to solution for founders as they are simple to issue in the pre-funding stage of a start-up’s life cycle. When it comes to employees, advisors and consultants we recommend share options rather than shares.
In this article, we’ll answer the following questions:
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What is the difference between shares and share options?
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Who should get which and why?
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How do I award my employees with options?
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Shares vs. Options
The most fundamental difference between shares and options is that when you grant someone shares, they are immediately a shareholder in the company; in contrast, if you grant them share options, that gives them the right to buy shares in future.
Put simply, shares give immediate ownership of equity in your company and enjoyment of the share class rights, while share options allow for the future opportunity to own a part of the business. For more detailed information, see our article on Shares vs. Options: What’s the difference?
It’s good practice to only have co-founders and investors holding shares on the cap table. You may find our guide on what separates founders from employees very useful when deciding who should hold shares rather than options.
Once you have determined who your employees, advisors and consultants are, the next step is to understand how vesting works. Vesting means that the shares or options are ‘earned’ over a period of time, and the person will own the full amount only when the full vesting period has passed. While both shares and options can be subject to a vesting schedule, they vest in fundamentally different ways.
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Shares are issued and allocated to the shareholder upfront, and then they reverse-vest. If the shareholder then leaves the Company before the end of the vesting period, then they will be required to sell their unvested shares back to the company.
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Options, on the other hand, forward-vest. The option holder is granted options and they earn them over a period of time. If the person leaves the company before the end of the vesting schedule then the unvested options lapse.
If you want to explore vesting in more detail, check out our article on Shares and Option Vesting Explained.
Due to the nature of reverse-vesting, shares immediately make the employee a shareholder in your company. That, in turn, gives them rights and powers in the business, which may not be ideal as they are not part of the founding team.
Why should you issue Share Options to your Employees?
While issuing shares may seem far simpler and less confusing compared to Options, it can cause you significantly more complications in the long run.
Options are preferred by many founders because:
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they do not immediately allow employees any control of the company, such as voting power;
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they do not afford employees with shareholders' rights, such as information rights;
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should something go wrong and the employee leaves the business, there is no need to then buy the options back as the unvested options will lapse- in comparison, with shares, you would need to buy back the shares that have not vested.
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you can control when the options are exercised - such as only when the employee leaves or only on the sale of the company, for example
Therefore, giving your employees options does not give any immediate rights or control and instead, they are earned over time. The options can then be exercised and converted into shares. When it comes to your wider team of employees, consultants and advisors, we recommend that you award them with options as transferring shares back (share buyback) in the event someone leaves can be a complicated process.
During your funding negotiations with investors, you would most often agree to a valuation of your company pre-funding. Once you have agreed on a valuation of your company or are in discussions about a company valuation, there may be additional tax implications if you issue shares to individuals directly, so you would need to consult an accountant. This is because your shares will have a market value attributed to them, so there would be a tax implication to issue shares at a lower value. These same considerations apply if you are at a post-funding stage.
How to give Options to your team of employees
At SeedLegals, we have simplified the process of granting options a lot. For more detailed information, check out our article on How to create an Options Pool and give options to your team.
Broadly speaking, giving options to your employee team consist of three steps:
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Step 1: agree to give options to your employees, with a share options vesting schedule. This is done by issuing an employee/advisor/consultant agreement.
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Step 2: Create a Share Options Pool on your SeedLegals Cap Table (see article here: How to create an option pool)
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Step 3: Create an Options Scheme
On the SeedLegals platform we offer Employment, Consultancy and Advisor agreements - and all of them contain provisions regarding option vesting. It is important to note that you can create and sign these agreements without first setting up an Options scheme.
To set up the Share Option Pool you need to get the permissions of existing shareholders and the board to reserve equity that can be created and issued in the future. You might also require investor majority consent if you have this term from a previous funding round. The shares in the option pool don’t yet exist in the company’s share capital until the employee exercises their share options.
Setting up the Options Scheme allows you to outline in detail the terms under which the options will be exercised (turned into shares) in the future, and - most importantly - the tax implications around that. It is important to know that there are two types of Option schemes we offer:
To find out more about these schemes and who is eligible for each of them, please see our article on EMI or Unapproved Share Option Scheme – which is best for you? You can also take a look at our helpful video guide on how to navigate the Options tab on the platform.