In this series we have considered what EMI options are and what issues companies should consider before entering into a scheme. We have also discussed what is available if a company, or an employee, is not eligible to enter into an EMI scheme and we have set out some alternatives to EMI schemes with brief advantages and disadvantages of each scheme.
In this blog we are going to consider what issues to look out for when considering how EMI options inter-relate with the company’s exit strategy.
Exit events – Practical considerations
It is common for EMI options to be drafted so that they are only exercisable on the occurrence of an exit event.
An exit event could be the sale of all the shares in the company; a change of control; a business sale or a listing on a stock exchange.
By limiting the exercise of an option to an exit event, the option holder will only become a shareholder immediately before the exit event happens. The option holder will therefore share in the benefit of any uplift in value of the price of the shares under option since the option was first granted to them. This can be an effective tool to recruit and retain staff if there is a clear strategy to work towards an exit event.
From the company’s and investor shareholders’ perspective it makes life easier only to have employee shareholders for a very short period of time. This will ensure that the employee will not have access to sensitive information which an employee could take with them when they leave or tell other colleagues. It also avoids having to buy back shares from employees when they leave the company at a time when the company or other investors may not have sufficient resources to buy back the shares from the employee.
It also reduces the risk of having to negotiate the purchase of shares by the company or other investors from an employee as part of a settlement agreement if an employee’s employment contract is terminated. It is not uncommon for EMI options to be drafted so that they automatically lapse if an employee leaves the company.
Take over/sale of the company
If EMI options are only exercisable on the occurrence of a take over/sale of the company it is vital to ensure that all the options are exercised before the completion of the takeover/sale and if not then they automatically lapse. A buyer will not want to acquire a company which has un-exercised options over the target’s shares which are still capable of exercise.
We normally recommend that the option provides for a time scale notified by the directors by when the options must be exercised and if not exercised within that period they lapse.
Provided the exercise of the options are properly structured, the company will have the benefit of a deduction against profits chargeable to corporation tax in the accounting period in which the exercise of the options took place. The amount of the deduction is the difference between the market value of the shares at exercise and the amount paid for the shares. This is a valuable benefit for the company and the buyer so a seller should factor this in when negotiating price. To qualify for the deduction the options need to be exercised before the company is taken over so the timing of when the exercise takes place is crucial.
Another consideration to make life easier when the options are exercised before a take over is to allow the options to be exercised on a cash free basis. From an employee’s side, not having to find the exercise price in cash can be very helpful and from the company’s perspective it saves the administrative exercise of coordinating the collection of cash from multiple individuals. Instead the amount owed for the shares purchased on exercise of the options is deducted from the cash proceeds of the shares that are sold to the buyer on the sale.
It is also important to structure the options so that the options are not exercisable in the event of a company reorganisation if for example a new holding company is to be placed on top of the existing company. This would not normally be an occasion for an option holder to exercise their options. To preserve the qualifying status of the options in such a situation (as an EMI qualifying company cannot be under the control of another company) new options will need to be granted over shares in the new holding company in place of the existing options.
Sale of business
In certain circumstances it may be more beneficial to sell the business of the company rather than the shares in the company. In such circumstances it is usual for the option holders to join in and exercise their options. We would normally advise that option holders be allowed to exercise their options if the whole of the business is sold as opposed to only part.
Likewise we would normally recommend that the directors set out a time line by when the options must be exercised by the option holder otherwise they lose their options. The company will then know exactly how many shareholders it will be distributing the proceeds of the sale of the business to.
Once the option holders become shareholders they will be entitled to join in a members voluntary liquidation of the company or receive a large dividend of the disposal proceeds of the business.
Whilst this exit route is less common than a trade sale for many early stage tech companies it is normal for an option scheme to cover a listing event.
As with takeovers and business sales we would normally recommend that the rules set out a time period as to when the options are exercised by and if not exercised they lapse. The rules should also cover situations when the grant and exercise of options may be restricted by the listings authorities.
If you are preparing for exit then it is always sensible to review the terms of your share option scheme to ensure that it is fit for purpose. If there are changes that are needed with an exit in mind, it is much better to take advice and implement those changes in advance without the pressure of an exit transaction already being underway.
It goes without saying that a buyer will conduct careful diligence on the scheme to ensure it is confident not only as to the number of options to be exercised, but the process involved and the EMI status of the relevant options being exercised. This process should run smoothly if you have promptly filed the necessary HMRC valuations, notifications and returns when options have been granted and you continue to maintain accurate records of your option documentation.
If you are considering setting up an EMI option scheme or one of the other schemes discussed in our previous articles, or if you have any related questions then feel free to get in touch with an expert by contacting Angus Bauer, Partner at Ashfords LLP on firstname.lastname@example.org.
Article produced in partnership with Angus Bauer and Rory Suggett at Ashfords.