How to allocate equity to your team

Early stage tech founders ask us all the time…

“How do I allocate founder equity and how do I think about incentivising my team with equity…?”

Shares, growth shares, flowering shares, options, EMI options, approved, unapproved, HMRC, employment related securities, vesting, leavers, etc etc.

The issues to consider are involved. And, alas, the issues do not scale down alongside the size of the company.

In fact, the opposite may be true. Getting the equity structure wrong at the outset may have a major negative influence on the company’s chances of succeeding. Fixing issues later on can also be eye-wateringly expensive, but the founders may have no option if fixing them is a condition to a VC investing. Occasionally, issues cannot be fixed at all.

Shares (ordinary/growth)
Ordinary shares will usually entitle the holder to a return of capital on a sale, IPO or winding up.

Growth shares will usually only participate in the proceeds above a specific hurdle figure.

If there is institutional money invested in the company then the management equity will likely rank at the bottom of the preference waterfall. See our deep dive on the subject here.

Options
Option holders will not usually see any return of capital on their options since the underlying shares will not yet be issued.  (Of course, optionholders will see participation in a return of capital when and if they become shareholders.)

Many options schemes will have sale, IPO or liquidation as a trigger for exercise, these are so-called “exit only” schemes.

Shares (ordinary/growth)
Ordinary shares usually entitle the holder to receive dividends.

Growth shares may not entitle the holder to dividends until a valuation hurdle has been reached.

Options
No entitlement (because the underlying shares do not yet exist).

Sometimes phantom dividends are looked at, but these can be somewhat complex (and therefore expensive) to structure.

Shares (ordinary/growth)
Yes, usually. (Share classes can be designed without voting rights.)

Options
No. The underlying shares have not yet been issued and so there is nothing to confer voting rights (until the options are exercised and the shares are issued).

Shares (ordinary/growth)
Rather obviously, shares do not normally allow qualification for any approved share option arrangements (which means that the shareholder cannot access the corresponding tax reliefs).

Options
Employees granted with options may qualify for one of the approved share option arrangements and therefore qualify for potentially significant tax reliefs.

If the company can grant EMI options, participants can usually avoid the income tax charge and NICs liabilities on exercise.

Shareholders will also be taxed on the sale of underlying shares.

Shares (ordinary/growth)
Yes, can apply and will be housed in the company’s articles of association.

See HLaw’s deep dive on leaver provisions here.

Options
Yes, will usually apply and will be housed in the option scheme rules/option deeds.

Leaver provisions in an option scheme are generally much easier to operate since the shares have not yet been issued (and it is just the future right to be issued with them that lapses).

Shares (ordinary/growth)
Issuing ordinary shares to employees at less than current market value will usually create a dry tax charge for the employee and the employing company.

Growth shares are one way of seeking to avoid incurring such a charge. See our guide to growth shares here.

Note that it is not possible to agree a valuation with HMRC when issuing growth shares. You should factor in the present value of future cashflows and projections into the current value of the shares for growth share valuation purposes. Since the tax treatment hinges on valuation, it is usually advisable to obtain a valuation from a professional value to back up the position taken.

Options
If employees are granted EMI options, HMRC will generally agree a valuation prior to the grant so the tax implications are known.

EMI options granted at a discount to market value will be subject to income tax and NICs on exercise.

Shares (ordinary/growth)
As the company grows, issuing shares to employees can result in a long list of minority shareholders, which can be sub-optimal in many ways. Where growth shares are used, the need to obtain a valuation arises at each issue.

Options
Options on a cap table are usually shown as a single line item accounting for the whole option pool (with the breakdown of the pool between option holders recorded separately).

This has the not-insignificant benefit of simplicity for when talking to investors and managing the cap table generally.

Shares (ordinary/growth)
Granting shares to your employees can foster a strong sense of belonging for your employees.

If an employee is granted shares, they will receive a share certificate and will usually be listed at Companies House as a shareholder in the next confirmation statement.

Options
Granting options is usually economically similar to issuing shares.

However, employees will only receive an option certificate, which may lead employees to feel less valued by their employers.

Options are not registered at Companies House but will need to be reported to HMRC.