The Difference Between Options and SharesPublished on: November 17, 2017 | by: James Farha
A common question for many founders giving team members ‘equity’ in their business for the first time, is what are options and how do they relate to shares in the company?’ We’ve set out the key things you need to know about EMI options below.
1. OPTIONS ARE NOT EQUITY PER SE
Options over shares are not shares themselves. They are the right to acquire share in certain circumstances at a given price
For example, the right to acquire a share immediately before a sale of the business for £1 per share.
2. WHAT HAPPENS TO THE CAP TABLE
When you give your employees options over shares, no new shares are issued. So if you want to know the value of the company if you sold it tomorrow, you would need to add the number of vested options over shares in issue to the total number of shares in issue.
For example, Company A has 100 shares on its register and these are showing at Companies House.
It has a 10% option pool, of which 5% has been allocated but only 3% has vested (i.e. 5 shares have been allocated to team members but only 3 of those shares have so far been earnt under the terms of the option agreement).
If someone wants to pay £1000 for the company as a whole then the value of each share will be £1000 / 103 giving a price per share of £9.71.
At the time of the acquisition, the company would issue the additional 3 shares to the option holder, and the option holder will, therefore, receive £29.13 out of the £1000 sale proceeds.
3. WHEN OPTIONS VEST
Vesting is the process by which option holders earn the right to turn their options into shares.
The most common structure in startups is vesting over 4 years, with a 1-year cliff. This means that in order to receive the full entitlement to options, the option holder must work for four years. In the interim period, the option holder earns a proportionate right to shares.
In the case of four years vesting with a 1-year cliff, the option holder will earn nothing for 1 year. Then they will get a fixed number of options on the 1 year anniversary (for example 25%). The rest of the options will then vest monthly or quarterly over the following 3 years in equal amounts.
If the option holder left the company during the period of those 4 years, they would only be entitled to the vested options and in some cases, leaving the company can cause all of the options to be taken away from the employee.
4. OPTIONS PROVIDE FLEXIBILITY
One of the key benefits of options for companies is that they are simple to manage. Option holders never actually become shareholders until both (i) the option has vested AND (ii) they have exercised the options. This vastly reduces the administrative work involved in incentivizing employees with shares. If an employee is fired, the options can simply fall away and no clerical work is required to remove the options that have been provided to them.
5. REVERSE VESTING AND SHARES
In some cases (often with co-founders) the company will give the shares to the relevant co-founder and then require that the person remains with the company over time in order earn the right to keep the shares. This is ‘reverse vesting’ and is used essentially to make up for the fact that we don’t have the concept of ‘vesting’ in a legal sense in English law (unlike in the US).
In this case, the employee actually receives the shares and either is subject to a requirement to transfer them to other shareholders when leaving, or those shares simply become ‘deferred shares’ with no rights or value attaching to them.
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