How do share options work?

A share option agreement is a legal contract that grants the right to buy a company’s shares in the future, but at a price that is fixed today. If the value of the company increases over time, option holders could make a significant profit when they sell their shares. Conversely if the shares don't go up in value there is no obligation to buy the shares, so an option is basically risk free.  

As an example let’s say that you're given an option to buy 1000 shares at £5 each, at any time in the next ten years, so long as you are still an employee when you want to buy them.  After six years, the company is sold to a big competitor, at £50 per share. You exercise your option and buy your shares, which costs you £5,000, and you then sell them to the buyer for £50,000, making a gain of £45,000. 

Share options are popular with growing companies who can offer them to attract talented staff. The opportunity to buy shares, to be a stakeholder and benefit in the company’s growth alongside the owners, provides a powerful motivation when offered in addition to the usual salary package. 

An option agreement will be formalised in a legal contract, which will include the rules and conditions. Option scheme design is very flexible, for example in specifying when the employee can actually buy the shares.  In terms of protecting the company, the agreement will also cover issues such as what happens if an employee leaves the business; usually they would lose their options or shares automatically or subject to the board’s discretion. The option shares can also have different rights, for instance they could be non-voting.

The impact of tax on an employee’s share gains is of course a crucial aspect that needs to be well managed. Outside of an EMI scheme, an employee who makes a profit on their company’s shares would pay income tax and possibly national insurance on the profit - this could be 50% or more in total.  Not exactly an incentive! Instead of a 50% tax hit, the EMI replaces it with a 10% capital gains tax charge. More on this in the next blog.