Unapproved share options: What are they?

How are unapproved options taxed?

Unapproved options can involve three different types of tax: VAT, Income Tax, and CGT. Here we'll explore common scenarios and the tax implications.

Don’t worry if you don’t fully understand how it works - it’s complicated, and not every rule applies to everyone. If you’re ever in any doubt, seek professional advice.

1. Granting options to employees and directors

• At grant: No tax is usually due when options are granted to employees, directors, or non-executive directors.
• At exercise: Tax arises when options are exercised. If shares are sold immediately, Income Tax and National Insurance are calculated on the profit. This is handled through PAYE by the company.
• Valuation and tax: If shares aren't sold immediately, tax is based on the shares' value at exercise time. Choosing between Actual Market Value (AMV) or Unrestricted Market Value (UMV) affects the amount of Income Tax and future CGT.

2. For non-employees in the UK

• Options as payment: When non-employees receive options, they are often viewed as payment for services. Individuals face Income Tax or CGT, while companies are subject to Corporation Tax.

3. Understanding VAT implications

• VAT on unconditional options: VAT is due if options provide immediate value (like an exercise price below the current market value). The recipient must invoice the company for this value, including VAT.
• VAT on conditional options: VAT is considered at each vesting event for options with vesting schedules. The recipient treats the market value of vested options as income from services and accounts for VAT on the difference between the exercise price and this market value.

4. Employer's National Insurance Contributions

When an employee exercises their unapproved share options and acquires shares that are classified as Readily Convertible Assets (RCAs) (which occurs when the shares can be easily exchanged for cash in an open market), the company is liable for the Employer's NIC. That's because, for tax purposes, RCAs are treated as cash.

5. Offset scheme costs against Corporation Tax

If your company grants the unapproved share options, you can offset the scheme's costs against your CT bill.

If you have granted unapproved share options to employees on your payroll, you can claim a CT deduction equivalent to the Income Tax Charge the option holder pays (the difference between the market value of the shares at exercise and what the employee pays for them).

EMI options vs unapproved options

While they share similar end goals and purposes, approved and unapproved share option schemes differ in their underlying mechanics. And they suit different applications at different stages of business growth.

That said, if a business is eligible for an approved scheme like EMI, then that’s nearly always the best choice due to the tax benefits. But unapproved option schemes have unique advantages of their own - so don’t write them off.

Here’s a chart comparing the two:

Do I need a valuation before granting unapproved share options?

No, a formal valuation is not required to set up an unapproved option scheme, but it can be useful for several reasons:

• For employees or directors: Granting options below market value to employees or directors has no immediate tax consequences. However, you must report the value of your business at the point of grant during your annual notification to HMRC.
• For UK non-employees or companies: If options are granted below market value, there may be an income tax liability, making the valuation important to inform recipients of potential tax liabilities.
• For international employees: In some countries, there is a tax liability for options at the point of grant. For example, for granting options in the US, obtaining a 409A valuation is important as the grant of options can create a tax liability for recipients.

How to set up an unapproved share option scheme

Thinking of setting up an unapproved option scheme? Book a free, no-obligation consultation with an equity expert and they'll show you how easy it is on Vestd.

However, you choose to go about it, be sure to complete these key steps:

1. Check that you have enough shares to work with

Lots of founders set up their UK limited company with 100 shares, with a nominal value of £0.01 per share. You may be one of them.

While there’s nothing wrong with that, it’s a pain if you want to set up a share scheme or raise funds because you only have 100 shares to play with.

That’s where subdivision comes in - it makes your company's share capital more liquid so there are more shares to set aside for an option pool or give to investors, but not at the expense of your own stake.

Vestd’s guided workflow makes subdivision simple.

2. Create an option pool

An option pool is a designated amount of the company's equity set aside for share options. It represents the total percentage of equity that can be allocated to employees and other eligible participants in the form of options.

The size of the option pool will depend on the company's current valuation, growth plans, and how much it wishes to incentivise its staff.

A typical range is between 5 to 20% of the company's total equity, but this can vary widely. The average among our customers is 16.5%.

3. Get board approval

Establishing an option pool requires the company's board of directors' approval. This step involves presenting a proposal for the pool size and its impact on the company's capital structure.

4. Determine the exercise price

The exercise price, also known as the strike price, is the price an option holder will pay to purchase their vested shares. It’s important to strike a balance here:

Too low an exercise price and the option holder will pay more in tax. Too high an exercise price may put people off exercising (buying) their options at all.

The exercise price should be fair and align with both the company's and recipients' best interests.

5. Design a vesting schedule

The whole point of options (really) is that they vest i.e. the individual earns the right to them over time. What that vesting schedule looks like is up to you. It could look something like this:

25% of the total allocated options vest every year for four years following a one-year cliff.

That’s a common time-based vesting schedule. 75% of our customers choose time-based vesting for their schemes.

Irrespective of that, options can be exit-only or exercisable.

• Exit-only: Option holders can only buy their options when an exit event occurs e.g., the company is sold.
• Exercisable: the option holder doesn’t have to wait for an exit (nor does an exit have to happen) before they can buy some or all of their allocated options.

On top of all this, you can apply performance-related conditions too.

• Performance-based vesting: The vesting of options is linked to achieving specific company targets or performance goals. Performance metrics might include revenue targets, profitability, or other key performance indicators.

There’s a lot to unpack here. If you’re stuck, hop on a call with one of our equity specialists. You can book a call at a time that suits you and get all the answers you need. We also have a free guide that covers best practices for share scheme design.

Grant unapproved options on Vestd

To grant unapproved share options, you could do it yourself (and risk getting it wrong) or ask a professional to take care of it (and pay through the nose for the privilege).

OR you can make the most of the tools available, like Vestd, and tap into our team's specialist knowledge.

Unapproved options – along with EMI, Company Share Option Plans (CSOPs) and growth shares – can all be set up and managed on Vestd. But that's not all...

Check out Vestd's full list of time-saving features.

Further reading and resources

• Granting options to those outside the UK
• Notifications for unapproved options
• How options are taxed
• Valuations for unapproved options
• Equity Fundamentals
• The Complete Guide to Company Share Schemes
  
• The Conditional Equity Guide

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