An Employee’s Guide to Share Options and ESOP

What's a share option?

You might see people talk about ‘share options’ and ‘stock options’. These terms refer to the same thing: share options are more commonly used in Europe, while stock options are more often used in the US.

Shares and share options are not the same. A share is a unit of ownership in a company; it almost always costs money to acquire shares. A share option is the right to buy a share at a point in the future. Companies can give share options to employees without any money changing hands. Share options turn into shares once the options have vested and an exercise window has opened (more on those later).

Share classes and voting rights

Companies often have different classes of share represented on their cap tables. Virtual shares or phantoms are almost always classed as common shares in your company. Common shares differ from preferred shares, which are usually the class of share held by investors. In case you’re wondering, it’s typical for founders to also hold common stock.

In most companies, shareholders get to vote in annual general meetings and when there are particular events that are important to the company, like when board members and/or company directors change. Share options don’t come with voting rights, and even when you convert your options into shares, it’s rare for common stockholders to have the right to vote on these kinds of resolutions.

The value of your equity

It seems like a simple question: how much is my equity actually worth? But too often, employees find it difficult to understand the value of their share options. So what information do you need in order to understand the monetary value of your ownership stake?

The data you need to value your equity

• The number of share options you’re being granted. You should find this in the share option agreement between you and your employer.
• The latest company valuation. Companies with approved ESOPs should be able to share an upto-date valuation with you, which will have been vetted by the relevant tax authority. Factors that influence the company valuation can include the rate of revenue growth, margin and profitability, and macro economic conditions affecting the sector.
• Your ownership percentage. It’s important to know what percentage of the company’s fully diluted share capital you’ll own when your options are converted into shares.
• The strike price you’ll need to pay to turn your options into shares. Again, companies with approved ESOPs should have agreed the strike price you’ll be asked to pay to exercise your share options and become a shareholder.

How does your share option turn into a share, and then into cash, over time?

At each stage, your equity means something slightly different. Initially, you have an agreement to own a stake in your company at some point in the future. Then, over time, you acquire a real slice of the business. And finally, depending on what you choose to do in a liquidity event, your shares turn into cash.

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But you need a liquidity event to happen first: without a secondary share sale, tender offer, IPO or acquisition, your equity won’t turn into money in your bank account. And at each stage prior to the liquidity event, the value of your equity will only ever be a guide.

There are a couple of things it’s important to remember. Firstly, stock options often have expiration dates, meaning that if they are not exercised within a certain period (for example, 10 years from the date they were granted), your options may no longer be worth anything. You need to be aware of this deadline if it exists.

And finally, don’t forget that you’re acquiring a stake in a young, ‘high-risk’ business. If the share price increases, your financial gain from your equity will increase too. But if the company valuation or share price falls, your shares could end up being worth less than you agreed to pay for them. We’ll also cover the impact taxes have on your financial outcome later on.

Fundraising, exits and taxes

When companies raise money, there are a number of knock-on effects for your equity stake. Dilution happens when new shareholders acquire stakes in a business, reducing the ownership percentages of the pre-existing shareholders. Although the number of share options each employee owns remains stable (outside of top-up grants), the percentage of the company those share options represent is reduced as the company issues additional shares to new investors.

A liquidation preference clause dictates that investors with preferred shares get paid some, all, or a multiple of their investment before common shareholders (such as founders and/or employees) get payouts in the event of a liquidity event such as a sale or public listing.

However, if new investment comes with a higher company valuation, the value of employee share options can still increase. For example, let’s say Alice, an engineer at flight search engine Flewgle, has been granted 15,000 shares of her company’s fully diluted share capital. If Flewgle has 600,000 shares in total, that represents 2.5% of the company. When Alice is granted her shares Flewgle is valued at £3 million, making Alice’s stake worth £75,000.

Then, in the next fundraising round, Flewgle raises £400,000 and issues 100,000 new shares to Bigg Capital, the company’s new investor. Alice’s 15,000 shares now represent 2.1% of fully diluted share capital. If the company valuation had remained at £3 million, the value of her stake would slip down to £63,000. However, Bigg Capital invested at a new higher valuation. After the funding round, Flewgle is worth £5 million – making Alice’s 2.1% stake worth £105,000.

It’s not always that simple, though. Investors often have anti-dilution clauses in their contracts designed to protect the value of their shares. These include liquidation preferences, which ensure that the investor receives a minimum return on their investment. This can have a significant knock-on effect for other shareholders. Ask your company whether any investors on the cap table have these clauses.

The exit – cashing out

At some point, every shareholder will look to realize a cash profit from their investment. As we’ve already covered, this usually requires a liquidity event, which gives investors the opportunity to sell or exchange their shares for cash.

Usually, a liquidity event means an acquisition, merger, or IPO. During acquisitions and mergers, the acquirer typically buys out shareholders, receiving some or all of their shares in exchange for cash. An IPO means the company lists on a stock exchange, making it much easier for employees and investors to sell shares.

Taxes

Of course, where there’s profit, there are taxes. With most ESOPs, you don’t have any tax to pay until you sell your shares. Many ESOPs, like EMI in the UK and BSPCE in France, are designed to reduce your tax burden when you sell shares by treating profits as capital gains rather than income. In the UK, for example, this means paying between 10% and 20% tax when you sell your shares, rather than 40% or 45%.

Other ESOPs don’t have the tax authority approval, which means you might have a higher tax bill to pay. Ask your employer if you’re not sure what type of ESOP your company uses. In other countries, notably Germany, tax is paid when employees exercise their options and when shares are sold, making total tax obligations much higher.

Moving on: what happens to your share options?

Almost all of us will move on from businesses at some point. But how much of your equity stake you keep when you move on depends on the circumstances under which you leave the company, as policies often change depending on whether you’ve chosen to leave the company or if your role is being made redundant.

Good and bad leaver clauses

What makes someone a good or bad leaver?

Companies can define good and bad leavers however they choose, usually drawing on the advice of their lawyers.

The most common cases that see employees defined as a good leaver, and hold on to their vested share options after they leave the business, are:

• Retirement;
• Serious illness or death (in which circumstance the employee’s share options would transfer to the next of kin);
• Being made redundant through no fault of their own, e.g. as a result of a merger, or because the role is no longer necessary.

In contrast, bad leavers lose the right to retain any shares or share options after moving on. Bad leavers often include employees who:

• Commit gross misconduct;
• Are convicted of a crime, such as committing fraud or embezzlement;
• Break a noncompete clause or violate the terms of a shareholders’ agreement;
• Voluntarily resign, or before reaching a certain milestone, e.g. before all their shares have fully vested;

Ask your company whether they treat people who voluntarily resign as good leavers or bad leavers. If you’re treated as a bad leaver when you resign, that means you’ll lose your rights to your share options – even those that have vested.

Exercise windows are usually opened for people who move on from the business. If you are able to keep hold of your equity after you leave, it’s worth asking how long your exercise window will be open for. Often, leavers are given just 90 days to exercise their options or lose them forever. This potentially means coming up with a significant amount of money in a short amount of time in order to buy your options from the company. More companies are extending exercise windows to several years, giving you more time to decide whether or not you want to pay to become a shareholder in the business.