Joe Lennon FCCA explains what you can do if your EMI option scheme is due to lapse in the near future.
When did you last check the terms of your Enterprise Management Incentive (EMI) scheme?
Also, can you remember when exactly the EMI is due to lapse?
These are important questions, especially if your EMI option scheme is based on employee options being exercised on an exit event. All EMI option contracts are valued for a timeframe of 10 years only. If your business was working towards an exit, usually in the form of a sale, and this hasn't happened in the first 10 years following the issue of the options, then the result is they will lapse.
If your EMI was based solely on an exit then this is potentially quite problematic. On the other hand, if you have other performance conditions (such as achieving specific KPI's) which allow exercise then this isn't an issue and the below doesn't necessarily apply.
In this post we explore the different routes available to you, as the business owner, and the pros and cons of each.
4 Options if your EMI is due to lapse soon and is based on an exit event:
As a strategy, this will likely be very demotivating to your staff. EMI's are usually granted to staff members deemed to be instrumental and highly influential in growing a business. If your employees have held options as part of preparing the business for an exit, to then suddenly lose their rights to benefit financially from such an event could prove very divisive.
Given the EMI was set up with them for that very purpose, leaving the options to lapse is akin to reneging on a deal you set up with your team. It could end up being a sure fire way of losing key members of staff. The fact an exit hasn’t yet materialised likely suggests their continued work and support is required.
For this reason we'd suggest that letting the options lapse is unlikely to be a viable option.
2. Allow the employees to exercise the options even though there has been no exit event
Your board will likely have the authority (depending on your company Memorandum and Articles of Association) to determine that the options can be exercised despite an exit having not taken place. However, this will prejudice the EMI status of the options meaning tax will then arise on the exercise!
The shares, which will be acquired by the option holders, will not be readily convertible assets (shares which can be turned into cash). This means income tax will arise on the exercise which will be chargeable on an amount equal to the fair market value of the shares less any exercise price paid.
The option holder will be required to pay income tax through self assessment but no national insurance will be payable. Whilst the option holder will own the shares, they obviously wont be selling them on the same day as they would have done in the event of an exit. Consequently the tax payable will need to be funded from their own money as opposed to coming out of the disposal proceeds (because there won't have been a disposal).
Another issue is potential income tax exposure could be quite high because option valuations are normally as low as possible so the difference between that and the fair market value may be quite substantial.
3. The options don’t lapse and continue to be exercisable on exit
As the option will have been in place for over 10 years this will prejudice the EMI status of the option. The advantage of this over the second approach is that tax wont arise until an exit occurs and the shares are sold. That means the tax liability can be funded from the proceeds of the sale.
Another difference is the shares would be readily convertible assets and therefore income tax and national insurance contributions would be due. The onus is on the business to withhold this through the PAYE scheme. Also, if the eventual deal value ends up being higher as more time elapses the amount of income tax arising could also be substantially greater.
4. Grant new EMI share options
Provided the business still qualifies to grant EMI options, new options could be granted under the existing EMI scheme. This is potentially the best solution as it protects the EMI status of the options and should continue to help motivate the employee in the manner originally intended.
If you have an EMI scheme that has been in place for many years, it would be wise to check when it is due to lapse. Then consider professional advice on the tax implications of whichever of the above options you decide to pursue.
This post was created on 20/08/2020.
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