How do EMI Option Schemes work?
An Enterprise Management Incentive (EMI) Scheme is a government-backed arrangement which enables small and growing companies to incentivize staff, offering equity in their businesses and significant tax advantages for employees.
At first glance, the scheme might seem complex, so here we break it down into its constituent parts. The following assumes that both the employee and the company in question are eligible.
An employee is offered the option to buy shares in their company. This ‘right to buy’ is formalized in an ‘option agreement’ and gives the employee the right to exercise his or her option to buy the shares at some stage in the future.
However, the price the employee will pay when they eventually come to buy the shares is fixed following an agreement between the company and HMRC.
This means that, even if the shares are worth, say, £5 each when the option is exercised, the employee will still only pay what they were worth on the day they were granted.
The option agreement will also explain in what circumstances the staff member will be able to exercise their option to buy the shares.
For example, some schemes enable employees to exercise their option to buy shares where they have been employed with the company for a particular number of years, or at an ‘exit event’: when the firm is sold to another person or company or gets listed via a stock exchange.
At the point the employee comes to exercise the option, if the value of the shares is more or equal to the shares’ value when the option was granted, no income tax needs to be paid. This is the primary tax benefit of the EMI Scheme.
This is to be contrasted with, for instance, gifting shares to an employee, where the market value of the shares would be taxed as earnings from the employment, or a non-EMI option to buy shares in a company where the same tax treatment would occur on exercise.
In an EMI scheme, if the company becomes more valuable after the grant is made, the extra value of the shares is received by the employee who exercises the option, and the uplift in price of the shares will not be taxable income, and neither will National Insurance contributions be payable.
When selling their EMI option shares, employees will usually be entitled to entrepreneur’s relief on the requirement to pay Capital Gains Tax on the proceeds of the sale, making the effective tax rate on shares granted in this way approximately 10%: a great way for companies to recruit and retain talent.
What About Options for Shares That Are Free?
Valuing options over shares that are free
In the vast majority of cases, our clients ask us to seek to agree a ‘nominal valuation’ with HMRC.
We have a 100% record in obtaining nominal valuations for our clients, even where they have been through multiple funding rounds with prices paid per share of several hundred pounds.
A ‘nominal’ valuation
Seeking a nominal valuation means that we ask HMRC to agree that the value of the share for the purposes of the EMI scheme at the date the options are granted should essentially be zero. This creates the greatest tax benefit for participating employees, who are entitled to tax relief on the value that they help create.
Seeking a nominal valuation does not mean that we are asking HMRC to agree that your company is worth nothing. The valuation relates solely to the shares over which EMI compliant options will be granted.
Bright Ideas Ltd
Bright Ideas Ltd is a tech start-up, developing an app for use in the mortgage industry. It has undergone a seed funding round, raising £250,000 from an investor at £100 per share. It has three developers which it wants to retain and incentivize, aiming to build value in the company and sell it within 5 years.
The company is eligible to operate an EMI option scheme, and its employees are qualifying employees (see our separate note for further details on this).
Option at ‘nominal’ value
In December 2016, the company decides to grant EMI options and set up a scheme. Following our proposal, HMRC agrees that, for the purposes of the EMI Scheme, the value of the shares over which options will be granted is nominal (i.e. free).
In December 2019, the company is sold at £150 per share and the employees exercise their option to buy the shares. However, instead of paying the market value when exercising their right to buy in 2019 (£150), they are entitled to pay the price agreed under the option agreement back in December 2016 (i.e. nominal/zero).
Under the rules of the EMI scheme, the employee is not required to pay income tax or national insurance contributions on any of this acquisition.
Where the employee comes to sell the shares acquired under the EMI scheme in this way he or she will be eligible for entrepreneur’s relief on Capital Gains Tax: this means that they will be taxed at an effective rate of 10%.
What About Options That Are Offered at Market Value?
Valuing options at market value
Whilst most clients ask us to seek a nominal valuation where the price employees pay on exercise is effectively zero (see above), companies sometimes ask us to agree a valuation with HMRC which represents the market value of the shares at the date that the option is granted.
The thinking behind this is that, if new hires are being brought on board after significant value has been created in the company, the granting of options at below market value does not create sufficient incentive to add more value from that point forward.
Bright Ideas Ltd
Carrying on with the example set out above, Bright Ideas Ltd is a tech start-up, developing an app for use in the mortgage industry. It has undergone a seed funding round, raising £250,000 from an investor at £100 per share. It has three developers which it wants to retain and incentivize, aiming to build value in the company and sell it within 5 years.
Option at ‘market value’
In December 2016, the company decides to grant EMI options and set up a scheme. Following our proposal, HMRC agrees that, for the purposes of the EMI Scheme, the value of the shares over which options will be granted is £100 (i.e. the market value).
In December 2019, the company is sold at £150 per share and the employees exercise their option to buy the shares. However, instead of paying the market value when exercising their right to buy in 2019 (£150 per share), they are entitled to pay the price agreed under the option agreement back in December 2016 (i.e. £100 per share).
In this instance, an employee must pay NICs and income tax on one hundred pounds per share.
The staff member will also need to pay Capital Gains Tax (CGT) on fifty pounds per share (that's the difference between the HMRC share price and the market value of the share upon exercise).
If we use tax rates for 2017/2018, and the staff member is a higher rate taxpayer (paying 40% tax), then he or she will get net profits of £103 for every share.
The equation is £150 minus income tax of 40% and NICs of 2% on £100, and CGT of 10% on £50 (the staff member qualifies for Entrepreneur's Relief). The employer must pay NICs of £13.80 per share: 13.8% of £100. Employers have the right to request that their staff members pay the company's NICs cost. This decision is made via joint election.
What are the conditions for EMI Schemes?
Companies may be unquoted or quoted. The firm will need to be independent and not a fifty-one percent subsidiary of another firm, or controlled by another firm (or controlled by a firm and persons linked to the firm). The company will be required to have gross assets of thirty million pounds or less and employ less than two hundred and fifty F/T staff members. As well, the subsidiaries must qualify and the company must have over fifty percent of the ordinary share capital of all firms it acts with. Joint ventures tend to cause complications with qualifying for EMI schemes.
A company must have permanent establishment in the United Kingdom. It needs to have a set place of business or have an agent who concludes contracts on behalf of the firm.
Also, the company must pass a qualifying trade test. This means that it must exist completely or mostly for the purpose of doing trade, or be getting ready to do so. A trade which is qualifying is a trade which is done mostly in the United Kingdom or in the United Kingdom only. It's done on a basis which is commercial and it's about accessing profits which don't come from a significant portion of activities which are classified as "excluded activities".
Excluded activities for Enterprise Management Incentive are identical to excluded activities for EIS.
Which Shares Qualify?
Shares for an EMI scheme need to be paid up fully and they must also be ordinary shares of the company which aren't redeemable. Restrictions linked with the shares need to be reported to option agreement participants or the option agreement must be connected to the company’s articles of association.
Which Staff Members Qualify?
In order to qualify, staff members must be employed at relevant firms for twenty-five hours a week or, if the amount of weekly work hours is lower, for seventy-five percent of the working time of the staff member.
Any employee that indirectly or directly controls more than thirty percent of share capital (for ordinary shares) in the firm may not be granted the EMI options.
Now, we've covered most of the rules for The Enterprise Management Incentive (EMI). At this stage, we'd like to let you know the primary stages of putting EMI plans or schemes into place.
Why Choose an EMI Scheme?
Companies use these schemes in order to "incentivize" their managers. When a manager knows that stock options are going to come into play if he or she remains loyal to the company, this may give the manager the incentive to commit to the company over the long term. Without this type of incentive, a manager may start to look around for another employer which does provide stock options (EMIs).
Now that you know more about The Enterprise Management Incentive (EMI) scheme and all that it offers, as well as how to get going with it, you may want to consider offering this type of scheme at your company. While it will take some planning and related tasks, it will definitely give your managers a reason to stay loyal to your company.