The Americans call them Stock Options. We call them Share Options. Either way, they let you give employees, consultants and advisors the right to buy shares in the company in the future, at a specified price (usually 1c per share or other close-to-zero price).
To be able to give share options to your team you need to do three things:
Create a Share Options Pool
Give options to your team, with a share options vesting schedule
Create an Options Plan
A Share Options Pool is simply getting the permissions of existing shareholders to reserve shares that can be created and issued in the future. No shares exist when the options pool is created, and there's nothing to file with Companies House. Think of them as virtual shares, waiting to be created when an employee exercises their share options.
But, importantly, creating this reserved pool of shares dilutes the existing shareholders. As an example, if there were 100 shares in the company, and you create an options pool of 10 shares, the shareholders now own 100 out of 110 of the what's known as the fully diluted capital in the company (which just means the shares plus the reserved options pool).
Because creating a share options pool dilutes the existing shareholders, it therefore needs the consent of the shareholders to create that pool of reserved shares. And the most convenient time to do that is as part of a funding round, where the shareholders in any event need to vote to approve the creation of new shares for the new investors.
And that's why you'll usually hear people talking about "a 10% pre-money options pool" - i.e. they're reserving an options pool that's equal to 10% of the shareholding in the company prior to the funding round (our SeedLegals data shows that around half of companies create an options pool in their first round, and the most common size is 10% pre-money). By creating the option pool just before the new investors get added in the new round, it's only the existing shareholders who get diluted by the options pool... which is generally what the new investors are going to insist on (you're promising them a particular % of the company for their investment, if you then tell them, oh, it's actually 10% less than that, you got diluted already, well, that's not something they're generally expecting, unless by prior agreement). Here is an interesting article on how to size an employee option pool.
Now, having created an options pool, the next thing is to give share options to your team. That's easy - if you use a SeedLegals Founder, Employee, Consultant or Advisor Agreement (you'll find them all in Team Agreements), they all contain sections that let you allocate shares or share options to team members.
Importantly, whenever you give someone shares or share options in return for work they do (as opposed to for a cash investment), those shares or share options should always be granted according to a share or share option vesting schedule. That means if the person leaves within, say, 3 years, they need to give back some fraction of the shares or lose the unvested share options. It's really important you do this, as without a vesting schedule if a founder, employee or advisor leaves the company they'll still own a chunk of the company's equity - which not only will be personally really annoying to the remaining team members, but if it's a big % of the equity can make the company uninvestible in the future.
Okay, so having created a share options pool and then promised share options to team members in their team agreements, there's one more thing to do, which is to create a Shares Options Plan.
The Share Options Plans specifies the detailed terms under which the options will be exercised (i.e. turned into shares) in the future, and - most importantly - the tax implications around that.
If you give shares options to someone, when they exercise those shares they'll be liable for capital gains tax on the difference between the exercise price (usually just 1p per share, though you can set any value) and the actual price per share based on the company valuation at that time. If that person is a consultant or an advisor, that's their tax problem, just like it's their problem to pay the taxes on any consulting fees that you pay them.
But for an employee, i.e. someone on your payroll, who you pay monthly PAYE and NI for, when they exercise their share options that can be deemed to be an employee benefit that you've given them, and the company may be liable for NI and other taxes on that. Since the share options could be worth tens or hundreds of thousands of Pounds across the team, that could be disastrously expensive for the company.
Fortunately, there's a solution to that, known as an EMI Options Plan. That's a plan created by HMRC where you agree with them a company valuation up front, and share options granted according to the plan incur no company taxes, and dramatically lower employee taxes, when exercised.
EMI Options Plan is only available to employees, everyone else just gets share options with no options plan, or with an Unapproved Options Plan (in both cases they consultant or advisor is liable for the capital gains on their options at the point they exercise them).
The good news is that all our team agreements that offer share options state that the share options are granted according to an EMI or other share options plan "when put in place by the company". Which means that this is something you can deal with later, generally a few months after your first funding round, once things have settled down. So, there's generally no rush to get this done, it just needs to be done before any of the team exercise their options.
You can set up an EMI Options Plan on SeedLegals, dramatically better, faster and cheaper than the usual several thousand Pounds charged by accountants.
Log in to your Seedlegals account to get started or book a free demo with one of our option scheme specialists.