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How to reward advisors, contractors and others with equity
Last updated: 17 April 2024 Sharing ownership to...
Unapproved share options: What are they?
Unapproved share options are an incredibly flexible way to motivate somebody with equity. Learn everything there is to know in this guide.
Written by Alan Clarke
Alan Clarke is an Equity Consultant at Vestd.
Page last updated: 23rd November 2023
Here, we unpick what unapproved share options are, how they work, when you might want to use them and who you can give them to.
Contents
What are unapproved share options?
Unapproved share options grant someone the right to purchase company shares in the future at a pre-agreed price. So instead of making someone a shareholder now, they can become one later (after they’ve put the work in).
Options vest, in other words, gain their full value over time, not immediately. How and when that occurs is outlined in a vesting schedule.
What does ‘unapproved’ actually mean?
There’s nothing dubious about ‘unapproved’ options. All that word means is that these share options don’t benefit from the same tax benefits as other government-backed option schemes like the Enterprise Management Incentive (EMI).
Non-tax-advantaged options might be a better name!
But on the upside, unapproved options are super flexible, enabling virtually any business to use them to quickly incentivise and reward talent (unlike EMI, which has a fair few stipulations). More on that later.
So, while unapproved options aren’t as tax-savvy, they are still an excellent choice for companies looking to give people some skin in the game.
What are the benefits?
Despite the lack of tax relief, unapproved share options still have plenty going for them:
1. Broad eligibility criteria
- No exclusions: Some sectors are excluded from approved schemes like the EMI. Unapproved options aren’t subject to the same restrictions.
- No maximum company size: Only companies with fewer than 250 employees qualify for EMI. That’s not the case for unapproved options.
And pretty much anybody can have them, including:
- Non-UK employees: Ideal for companies with an international workforce.
- Non-PAYE staff: Reward individuals not on the payroll, such as advisors, freelancers, consultants and contractors. Great for businesses who rely on both in-house and external experts.
- Part-time staff: EMI only applies to employees who work at least 25 hours a week or 75% of their total working time for the company. But with unapproved options, you don’t have to worry about that.
2. No limits
You can only grant options up to the value of £3m under the EMI scheme. But with unapproved share options, the sky’s the limit.
There’s no per-person limit either. With EMI, no employee may hold unexercised EMI options with a combined market value exceeding £250,000.
You can understand why more mature companies grant unapproved options once they’ve outgrown EMI.
3. Versatile
Companies can use unapproved options instead of, or alongside, EMI and growth share schemes.
So, no matter the shape or size of the business, it’s perfectly possible to set up equity incentives for all, to reward everybody who makes a difference, not just UK-based employees on the payroll.
4. Protect existing shareholders’ interests
Like other share option schemes, it’s up to the board as to whether the option holders will have voting rights when they exercise (buy) their options. This safeguards the interests of existing shareholders by preventing dilution of their voting power.
5. Conditionality
Unapproved option schemes can be conditional, so someone has to meet certain conditions before they can exercise (buy) their vested options. E.g. Stay with the company for an agreed period of time.
You’ll find plenty of examples in our free conditional equity guide. Grab yours.
It’s a smart way to retain and motivate somebody while protecting the business should that person leave the company on bad terms or simply not deliver.
6. Simple to set up
Setting up an unapproved option scheme tends to be faster and less complex than tax-advantaged schemes, as there are fewer regulations and reporting requirements, and a valuation is not essential (though it is good to get one).
But it’s not the Wild West, you still need to get your ducks in a row. That’s where a share scheme platform comes in handy!
Why grant unapproved options?
Why give equity at all? Flexibility and versatility aside, unapproved share options are a simple way of giving your team skin in the game. And that’s the game-changer.
By doing so, companies can unlock the Ownership Effect. The reward? A team that’s incentivised to help the business succeed and stick around long enough to see it happen.
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.
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More info
When options are granted to employees, directors, or non-executive directors (NEDs), there is generally no immediate tax liability at the time of grant.
This applies regardless of the exercise price as long as the options are exercised within ten years of the grant date. However, a tax liability arises when the options are exercised.
- Upon exercise, if the shares can be sold immediately (e.g., during an exit event), both Income Tax and National Insurance (NI) are due on the difference between the exercise price and the sale price.
- The company must deduct and pay the Income Tax and NI through PAYE and then recover the amount from the shareholder within 90 days.
- In cases where there is no immediate market for the shares, the option holder can choose to pay Income Tax based on either the Actual Market Value (AMV) or Unrestricted Market Value (UMV) of the shares at the time of exercise.
- If UMV is chosen, the Income Tax bill at exercise will be higher, but any subsequent gains will only be subject to Capital Gains Tax (CGT).
- To avoid further Income Tax liabilities, both the recipient and the company must complete a joint ITEPA S431 election within 14 days.
- If AMV is chosen, the initial Income Tax liability will be lower, but the eventual gains will be subject to both Income Tax and CGT.
- Upon exercise, if the shares can be sold immediately (e.g., during an exit event), both Income Tax and National Insurance (NI) are due on the difference between the exercise price and the sale price.
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.
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More info
When options are granted to UK tax residents who are not employees, the options can be considered as payment for services. The tax treatment varies based on whether the recipient is an individual or a company:
- For individuals: Receipt of options is subject to Income Tax or CGT.
- For companies: Receipt of options is treated as revenue and is subject to Corporation Tax.
The tax liabilities for corporate option holders are similar to those for individuals, except that they are charged Corporation Tax instead of Income Tax.
Unconditional options tax liability
Unconditional options mean the option holder is not subject to any specific conditions or restrictions when exercising the options.
- Tax is created on the grant of options when the recipient receives immediate value, and no conditions are attached. For instance, the options vest immediately if the exercise price is set below the current market value (MV).
- In such cases, the recipient must invoice the granting company for the goods and services and VAT on the difference between the exercise price and MV.
Example: If a contractor is granted 1,000 options with an exercise price of £1, and the MV is £2, they would invoice the company £1,200 (£1,000 + VAT @ 20%). The company would pay the VAT to the option holder and recover the same amount from HMRC. As there is no vesting schedule, tax is due at the time of grant.
Conditional options tax liability
Conditional options come with several stipulations before an individual can exercise their options. Here’s how tax works for conditional options:
- Income Tax liability arises on the grant of options and each time they vest.
- The tax liability is calculated as the difference between the exercise price and the MV when the options are granted.
- The recipient will invoice the company for supplies plus VAT (or declare it as revenue for corporate option holders) each time their options vest.
- VAT is charged whenever the options vest.
- The tax liability increases with each vesting event.
- For individuals: Receipt of options is subject to Income Tax or CGT.
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:
| CRITERIA | UNAPPROVED OPTION SCHEME | EMI OPTION SCHEME |
|---|---|---|
Participants |
Open to employees, non-employees and key players overseas. |
Limited to employees and directors only. |
Company size |
No size or sector limitations. |
Not all sectors are eligible. Max 250 employees. |
Limitations |
No cap on the number or total value of options granted. |
£250k max option value per employee (based on UMV). The most a company can grant at any one time is £3m. |
Eligibility |
No specific eligibility requirements for the company or employees. |
Strict criteria like having assets of £30 million or less; employees must work certain hours. |
Tax |
Nothing to pay at first, only when exercised. High tax liabilities for the recipient. |
Nothing to pay at first, only when exercised. Employees usually qualify for Business Asset Disposal Relief. |
Vesting |
Custom vesting and exercise conditions. |
Custom vesting and exercise conditions with some caveats, e.g. 90-day exercise window. |
Ideal for |
Large companies with 250+ employees, international teams or those not meeting EMI criteria. |
Best suited for UK-based startups and SMEs with up to 250 employees. |
Management |
Quick and easy to set up due to fewer regulatory requirements. |
A little more complex. A HMRC valuation and annual notifications are essential. |
Do I need a valuation?
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 share 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.
Let's discuss tax-efficient shares & options!
Thinking about giving your team some skin in the game?
We'll help you understand how to design a share option scheme in next to no time. Calls are totally free and there's no obligation to use Vestd afterwards.
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