The ‘four year vest, one year cliff’ EMI share option scheme structure – how does it work?

The EMI scheme is by far the most beneficial type of share option scheme you can use for employees in the UK. The tax breaks are great, but EMI is also very flexible, with a great choice over arrangements for when options can vest and be exercised. Vesting is when employees ‘earn’ the options and exercise is when the shares can actually be acquired (so called because you are exercising your legal right under the option to buy the shares).

The only real caveat imposed by EMI legislation is that the options must be able to vest before the tenth anniversary of the date they were awarded, otherwise they lapse. The design of your scheme is crucial to incentivising employees as much as possible while also working well for the company. You may have read of the choice between having an exit-only or time-based scheme, and how you might structure those and the advantages of each type, and unsurprisingly scheme design is one of the key areas on which we are asked for advice.

Over the last few years our firm has been setting up an increasing number of EMI schemes using what I call the ‘hybrid’ design which is kind of a cross between a pure exit-only or time-based plan. The hybrid is typically known as the ‘four year vest, one year cliff’ option.

How does it work?

• Options are granted at an exercise price (or ‘strike price’) based on the company’s market value today but usually heavily discounted for EMI purposes. That price is agreed with HMRC and is crystallised for ten years. 
• Options can only be exercised on an exit (sale of the company) or possibly on leaving
• On the first anniversary of the grant date, 25% of the options vest i.e. are earned and belong to the employee
• If the employee leaves before the first anniversary, all options just lapse automatically (that is the ‘one year cliff’)
• After the first anniversary, the remaining 75% of the options then vest over three years in equal monthly or quarterly instalments, so that after four years all options are fully vested
• If an exit happens before all the options are vested, a scheme may allow ‘accelerated’ vesting, where any unvested options are immediately vested on the exit event so that everyone gets 100%
• If the employee leaves after the first anniversary, then typically, if they are a ‘good leaver’ they can either exercise or retain the options that have vested up to their leaving date 
• How to define a ‘good leaver’? There is a whole spectrum of definition, between defining a good leaver as anyone leaving for any reason except for dismissal for gross misconduct, to a good leaver being only someone who ceases employment due to their death or incapacity. We can advise on this but these days most schemes use a more generous definition of good leaver.

What is the key difference between ‘exit-only’ and the hybrid?

• The fact that with the hybrid, a good leaver can retain their options rather than typically losing them under exit-only

What are the advantages of this design?

• It may be seen as fairer to employees who have joined a company and worked hard for maybe three years but then leaves for valid reasons to be able to keep the value of their options
• While there is an argument that share options are aimed at encouraging employees to stay with a company, and view a leaver as breaking that principle and should therefore lose the options, you could say that we are now in a world where there is so much flexibility of employment that it is probably more counter-productive to take an overly strong view on this
• The more uncompromising view would deter a lot of very good candidates, especially if they might be paid below-market rates due to cash constraints in an early stage company for example
• It is only good leavers who would retain option rights
• The four year vesting sets a clear structure for when the options will be earned

Variations to the design

• The structure set out above is not set in stone and can of course be varied
• For example, use 3 year vesting not 4
• After the first 12 months, you could have instalments vesting annually, rather than monthly or quarterly
• If you are concerned that options lapse automatically after 10 years if there is no exit, you can use a 'long stop date' for exercise, for example the options can be exercised on the earlier of an exit or (say) a month before the tenth anniversary (or possibly even before that)

Why not use a time-based scheme - when is pre-exit exercise warranted?

• Options that confer vesting and exercise prior to an exit have their place, particularly for co-founders or quasi-founders, or for very early joiners
• It makes sense to enable such employees to buy shares (usually with dividend and voting rights) before an exit so they feel more like a real stakeholder compared with later employees
• Early stage pre-investment exercise prices will probably be cheap so they can lock into good value if they’re allowed to exercise and buy shares early enough
• The downside is that you have employee shareholders before an exit, which usually just causes admin headaches without giving any upside unless the company is paying dividends