The ultimate exit event for founders who have set up and successfully run their businesses is to sell, whether that sale is to a competitor, investor or private equity firm. A share option scheme has a part to play in that process and, often, some of the practicalities were not understood or explained when the scheme was put in place.
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Employees become sellers:
- Shareholder: once an option is exercised an employee becomes a shareholder and therefore also a seller at the point of a sale of the business.
- Many sellers means many documents: frequently we find that a business has offered the option scheme to many employees – we’ve had as many as 30 employees involved. This means that there will be a number of people who need to sign documents to complete the transaction. There are ways to simplify this, but we always find there are delays and processes to navigate. We therefore typically encourage schemes to only be offered to a few key management team members to keep the number of those with an option low.
- Options are optional: an employee does not have to exercise but, if they do, they hold shares and can later only be forced to sell their shares if there are special provisions in the articles or within a contract. These are called drag-along rights. So, when putting an option in place, have your articles amended to cater for this.
- Individual advice: option holders may need to be offered separate legal advice at the point of onward sale. They will, at least, need to be given an explanation of the documentation involved in the sale and to have questions answered. Although this has never been a blocker to a sale, it does have an impact on time and legal fees.
- Warranties: on a sale of a business, a purchaser expects the sellers to give warranties and various indemnities about the company. Such clauses can give the buyer a right to recoup consideration from the sellers and, sometimes, also the option holders. To manage this, either the buyer has to accept warranties only from the main shareholders (giving them less cover), or the option holders also have to take some risk on the sale. None of this is unusual, but it can be difficult to manage in the process.
- Confidential information: in a typical scenario, option holders see and sign the sale and purchase agreement under which all the shares are sold. The agreement contains details of the amounts being paid to each shareholder. Founders selling their business often express surprise that the option holders will know how much money they will receive. They then also express surprise that each option holder will know how much money each other option holder will receive. This can be a delicate matter and lead to conversations where a client has to justify to one option holder why they could not purchase as many shares as another option holder.
- BEWARE – Option errors: the most common issue we have with options is, however, imperfections or errors in the scheme. This happens frequently when the company has not taken proper legal and accountancy advice when putting the option in place. Frequently, schemes designed to be tax efficient have not met the HMRC requirements and, even worse, options have not been issued at all. In this scenario, founders end up paying bonuses which are taxed as income.
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Other potential issues:
- Unvested Options: share options usually have a vesting schedule based on a time period or performance criteria. If these have not been met then an employee can be left feeling disgruntled.
- Underwater Options: if the share value has dropped, then there is little point in the employee exercising. Again, this can lead to bad feelings.
- Forced Sale of Shares: employees may be forced to sell their shares as part of the exit strategy. This is usual but needs to be explained to them when the options are offered.
- Ambiguity in Terms: in some cases, the terms of the option scheme may be unclear or subject to dispute at the time of exit. There could be confusion in the interpretation of the vesting schedule or performance milestones.
In summary, while share option schemes can be highly attractive in theory, there are risks and potential downsides at the point of exit which employees need to be aware of when deciding whether to participate in these schemes. Founders also need to be aware of these and consider them when designing their option scheme. These risks often come down to timing, liquidity, tax implications and the structure of the exit event itself. There is no doubt though, that share options will remain a popular way of incentivising key employees.
If you are thinking of selling your business, setting up a share option scheme or understanding the implications of a scheme already in place, get in touch with our expert Corporate Law solicitors by email or call +44(0)3333 231580.
