What is a Share Option?By Money Mage · · Tax, Investing, What Is
Share Options are the Option to buy Shares in a company for a particular price, the strike price.
Share Options are often provided as an incentive when working at non-public companies. They are especially common in technology firms. They often form part of your package you negotiate when you join a private company, depending on the company and your seniority.
This article is about Share Options provided to you by your employer and not Deritivate Trading such as Put / Call options.
I have had plenty of Share Options over my 20-year career in Software. I have envelope after envelope of vested or expired share options in a cupboard - they’re all worthless or probably worthless. But recently some Share Options I had come to fruition and are now worth something. I’ve had to navigate the somewhat complex and confusing world of share options. The terminology used is often alien and confusing too: vesting, exercising, strike price, fair market value. It can be a minefield.
This What Is article is the Ultimate Guide to Share Options. Everything you’ll ever need to know. And if you need to know more, speak to a Financial Advisor.
Money Mage is not Financial Advice and is information and education only. Read the Disclaimer. If you are looking for personalised advice regarding your Share Options speak to a Financial Advisor.
What is a Share Option?
Share Options are a contractual agreement (share option agreement) between you and your company that allows you the option to buy (exercise) shares in the company for a particular price (strike price) over a particular period (vesting schedule)
The key is in the name. Share options are optional. You don’t have to buy the shares. And the choice of whether you buy, and when you buy, and how many you buy, is entirely yours.
This decision can be complex. As private companies are not listed, trading shares in a private company is very difficult if not impossible. Share option agreements may prohibit you from trading your exercised shares on secondary markets.
The decision of whether to exercise your share options is difficult and will depend entirely upon your situation and your companies’ situation. This article will help you navigate the key considerations.
What is the Strike Price?
The strike price of a share option is the price you must pay to buy the shares. You pay the company. You may do this directly, or via a broker.
For example, I have a share option agreement that gives me the option to buy 100 shares at a strike price of £1.
I have to pay the company £100 to buy the 100 shares.
But what are the shares worth? Are they worth £1?
What is Fair Market Value?
The Fair Market Value of a share in a company is the value of the share if it were to be traded.
For public companies the market value of a share is simple, it’s the value of the share determined by the public market.
But Fair Market Value for shares in private companies is much more complex. It’s a dark art. Accountants will determine a Fair Market Value based on several factors: comparable public companies, various ratios and metrics, like price over earnings (P/E), forecasting future cash flow, discounted cash flow, and revenues.
You don’t need to know how Fair Market Value was determined, you just need to ask your companies’ finance or stock admin department what the current Fair Market Value is.
The Fair Market Value is an important figure as it will help you navigate what tax you have to pay. There is also no point in exercising a share option if the Fair Market Value is below your strike price!
What is the Vesting Schedule?
Share options are often awarded as an incentive. An incentive to work harder. An incentive to stay at a company for longer.
To achieve this, share options are often ‘drip-fed’ to you in various ways - either based on time or performance or both.
The vesting schedule in your share option agreement will lay out the terms upon which you receive your share options.
Unvested share options are options that are due to you in the future if certain conditions are met. Vested share options are options that you have which you can now exercise if you wish.
For example, I have a share option agreement that gives me the option to buy 1000 shares at a strike price of £1. ¼ vests after 1 year working for the company, then the remaining ¾ vest monthly at a rate of 1/48.
After 1 year: 250 have vested and are exercisable After 1 year, 1 month: 270 have vested and are exercisable After 1 year, 2 months: 290 have vested and are exercisable
And so on.
Your vesting schedule may have performance criteria attached, like hitting certain targets. Check your agreement.
What is Exercising a Share Option?
Exercising a share option is ‘exercising your option to buy that share’. You buy the share from the company at your agreed strike price.
You will need to pay the company the strike price for each share you wish to exercise. Once exercised, you now own shares in the company and are a shareholder on the companies’ register of shareholders. Remember, private company shares are difficult or impossible to sell, and your share option agreement may prohibit you from selling on secondary markets.
In the UK, unless the share option scheme is an approved HMRC share option scheme, the exercising of share options is a taxable event treated as income. Income tax and NI contributions are due based on the difference between the strike price and fair market value.
What is a Lock Up period?
In certain liquidity events, like an Initial Public Offering (IPO) your share option agreements may have lock-up periods.
These lock-up periods prohibit you from exercising your share options for a while, usually 90 - 180 days. Check your lock-up agreement.
What is Dilution?
Share options can be diluted, just like shares. If the company raises more capital by issuing more shares, your options may be diluted. This may have a material impact on the value of your share options. If a company is valued at £1m and there is 1 share in circulation, the share is worth £1m. But if the company has 1m shares and is valued at £1m, the share is worth £1.
This is common if you are an early employee in a startup for example. Your grants will be diluted by any subsequent investment rounds.
What is a Share Option Refresh?
To combat dilution for certain employees, companies may offer share option refreshes. This is where you are offered a new set of options at a new strike price (likely the fair market value at the time).
This is completely at the discretion of the business.
How do I Exercise my Share Options?
To exercise your share options, speak to your finance department. You will need to pay the strike price per share, and you may also need to pay tax.
If your company is already public, you likely have a brokerage account where you can exercise your vested share options yourself without needing to speak to your finance department. You may be able to do this as part of a cashless exercise.
What are HMRC Approved Share Option Schemes?
HMRC has approved Share Option Schemes which have special tax treatment. Specifically, EMI share option schemes, Company Share Option Plans, Save As You Earn, and Share Incentive Plans.
These have special tax treatment, EMI share option schemes are especially attractive for employees, as the employee will not have to pay income tax or NI at point of exercise if you buy the shares for at least the market value they had when you were granted the option, up to £250K. Similarly for Company Share Option Plans but CSOPs have constraints on the class of share that is less attractive for the company.
You may still have to pay capital gains tax.
Check with your finance or stock admin team at your company whether your share options fall under a HMRC approved scheme, as this will be beneficial from a tax perspective.
What is a Cash Exercise?
A cash exercise is where you buy your granted shares at the strike price for cash, and also cover any tax liabilities with cash.
Speak to your finance team or stock admin team at the company you work for if you wish to do this. You will likely have to wire funds to the company.
What is a Cashless Exercise?
A cashless exercise is where you exercise your options and simultaneously sell some of your newly exercised shares to cover the cost of exercise (strike price) and any tax liabilities.
This means you as the employee is not out of pocket.
This is only usually possible at a liquidity event such as an Initial Public Offering (IPO) or if the company you work for is being acquired.
Exercising share options: Everything you should know
When should I Exercise my Share Options?
This is a really difficult question and one that only you can answer.
Here are some considerations:
- How likely is a liquidity event? Is the company planning to list on the public market? Is the company planning on being acquired? If this is looking likely, you may want to exercise.
- Is the future of the company bleak? Is it likely to fail? Exercising is likely not a sensible option at all.
- Is the company already public and you have vested options? You probably just want to exercise for the additional income.
- Is cash a problem? If so, you may want to wait for a liquidity event so you can do a cashless exercise. Note this may not be the most sensible financial option as the market value may be much higher at the liquidity event, so you might have to pay more tax.
- Do you believe in the company’s future? If not, you probably need to ask yourself a bigger question of why are you there.
- Are you going to leave the company, but you believe in the company’s future? You may want to exercise as unvested options often lapse if you leave employment.
The strongest signal is a liquidity event and your belief in the success of the company. If the company is doing well, and is talking about listing on the public market, or being acquired, then this is a strong signal.
You’ll never really know if the liquidity event is going to happen, but you can get a read of the situation. You’re then faced with when to exercise: cash exercise early, or cashless exercise later. This depends upon your cash funds and the likelihood of a liquidity event. If you exercise early for cash, the hint is in the word cash. You’ll need cash to pay your strike price (which may be thousands or tens of thousands of pounds) and also any tax liability. It may be tax advantageous as you’d pay tax on the difference between your strike price and Fair Market Value. If you wait until the liquidity event occurs and a cashless exchange is possible, the Market Value might be much higher, so you may have much more tax to pay if you wait.
If the company is struggling and traction isn’t happening, you might want to think carefully about exercising.
You may also want to exercise just a small amount of your shares - even just one share. That way you are a shareholder in the business, and the business must keep you informed about important company events. Although any company worth working for should be keeping you informed as an employee anyway…
A liquidity event is where shares in a private company become more liquid, i.e. they can be sold to other people.
Those other people might be the public on a public market after an Initial Public Offering. Or those other people might be another business that is acquiring the business you are working for.
Navigating Strike Price, Fair Market Value, and Taxation
Strike Price + Fair Market Value and Market Value all play a big part in exercising your share options.
The ideal case is that your options are part of HMRC approved schemes like EMI or Company Share Option Plans.
You can trigger a very large tax bill if you are not careful. Potentially tens of thousands due, in cash. You may need to speak someone qualified to advise you.
Let’s take an example of 100,000 vested share options with a strike price of £0.10. The Fair Market Value is now £1.
If you exercise for cash you have to pay 100,000 * £0.10 = £10,000 to exercise. You now have shares worth 100,000 * £1 = £100,000.
But this is a taxable event on the difference between the Strike Price and Fair Market Value. The difference is £90,000, which is classed as income. You’d be due income tax and NI contributions on £90,000 of income - which is a significant amount, about half if you are a higher rate taxpayer. You’d have a tax bill of £45,000 which you need to pay HMRC, in cash, now. So you might have just bought yourself 100,000 illiquid shares that have cost you £55,000 cash, you can’t sell the shares in a private company.
If your share option scheme is an approved EMI scheme, you wouldn’t have had to pay that income tax and NI.
Now let’s take this forward to a liquidity event. The company you work for lists on the stock market and the shares are now trading at £10.
You have 100,000 shares worth 100,000 * £10 = £1,000,000. One million pounds.
You sell them, but this is a realisable capital gains tax event, so you now have Capital Gains Tax to pay. You bought the shares at Fair Market Value of £1, so there is a gain of £9 per share. You’d have capital gains tax to pay on 100,000 * £9 = £900,000 less your Capital Gains Tax allowance.
Overall, your share options cost:
£10,000 - Strike price at exercise, paid for in cash £45,000 - Income Tax & NI at exercise, paid for in cash About £250,000 capital gains tax at the point of sale, paid for from proceeds of the sale.
But you are up £695,000. If you were able to foot the £45,000 tax bill and £10,000 cost of exercise.
Many people don’t have £55,000 sat around in cash in this example. So an alternative is to not exercise your options early for tax and wait for a liquidity event. Let’s consider the same situation, 100,000 shares at a strike price of £0.1 but you wait until the liquidity event.
A cashless exchange on the same day when the shares are trading on the public market at £10 a share.
You cashless exercise your shares:
£10,000 cost of exercise, paid for from proceeds of sale £495,000 tax and NI on income, paid for from proceeds of sale
You are up £495,000 - a difference of £200,000 compared to early exercise.
This demonstrates the complexity of share options. The example figures here show how you can quickly trigger large and unexpected taxable events that can put you out of pocket if you are not careful. If you are into significant figures with your share options, you may do well speaking to an accountant or financial advisor about how to navigate your situation.
Depending on your company’s situation, you may find your share options reside in a brokerage account. This brokerage account may be in a country other than your own. And it may be tricky to navigate.
Speak to your company for help and advice about how to use the tools they have provided you to manage and exercise your share options.
When exercising share options in the UK, the company is responsible for withholding any tax due. The company will withhold the maximum amount of tax due at the additional rate and NI which is around 47%.
So when you exercise, expect to see half the value of your exercised shares withheld by the company. If your marginal rate is not at the additional rate, tax withheld that should not have been will make it’s way back to you through your next payroll.
In the example above, these taxation figures can be extremely large, so don’t be surprised.
If your tax situation is more complex than just one PAYE employment, you will be able to file a self-assessment to make right your tax at the end of the year.
Foreign Tax and Tax Treaties
If your shares are in a non-UK company, taxes may be due in the country your company is registered. An example: if you have shares options in a US company and exercise them, you’d be due US federal taxes. You’d also be due UK taxes. You’d end up getting double taxed. Once in the US, and once in the UK.
There are tax treaties between some countries that permit single taxation. In this instance, the completion of W-8 BEN IRS form means that US taxes are not withheld by your broker, and you can transfer funds to the UK for taxation. Your broker can arrange this.
International tax treaties are beyond the scope of this article, so please do check with your broker or a financial advisor.
Transfer from International Broker to the UK
If you sell your share options via a broker, that broker may be in another country, and the translation may be in another currency.
Banks charge for international transfers. A next-day wire transfer from the US to the UK may cost you around $15. There is then the exchange rate, banks often don’t provide you with the market exchange rate - just like foreign exchanges, they add some margin so they make money. There is then also potentially an ‘international transfer receiving fee’ from your UK bank - maybe £20 or more.
Before you know it, you’ve paid 1-2% on the exchange rate, $15 for the wire, and £20 to receive the funds. This can rack up into hundreds of pounds just to make the transfer from an international brokerage account to your UK current account.
These bank charges are not obvious and can rack up.
TransferWise* is a service that lets you transfer at the market exchange rate for a transparent fixed fee. It’s free to open a TransferWise account, you’ll need to provide proof of ID. Once you have a TransferWise account, you can add different currencies for exchange - for example, USD and GBP. This will give you a unique bank account number in the US for USD, and a unique local bank account number in the UK for GBP. You can then do domestic transfers to TransferWise - for free, so all you pay is the fixed upfront exchange fee from TransferWise to exchange currency. Sign up with this link* for a free transfer up to £500.
I was able to transfer funds from a USD brokerage account to my UK GBP current account within 24hours, for fixed transparent fees that were less than half the fees that my broker + bank would have charged.
This article has given you an overview of everything related to exercising share options, and some of the tax implications. Depending on the sums involved, you should consider talking to a Financial Advisor. Money Mage is information and education and not financial advice, read the Disclaimer
A taxable investment account for the trading of investments & shares
Purchasing shares in a company at a fixed price defined in your option grant.
Fair Market Value
The value of 1 share in a private company, determined by accounting practices
A period where you are unable to exercise or sell shares in a company
Share Option Grant
The award of share options to an employee of a business, often as a reward or performance incentive. Grants usually award share options with restrictions such as time or performance, this is called vesting.
The right to buy a number of shares in a company at a set price. If you decide to buy, this is called exercising. You do not have to buy, the choice is yours.
Share Option Agreement
The legally binding contractual agreement between you and your employer regarding your share option grant.
The fixed price at which you can buy shares in the company defined in your share options.
The holding back of funds by your company or broker for taxation, to be passed to a tax authority.
Unvested options are options that are granted to you but have not yet vested, so cannot be exercised.
The terms upon which share options are made available to you, usually constrained by time or performance. For example, time-based vesting you may be granted 1000 share options but they vest 250 after 1 year of employment, another 250 after 2 years of employment, etc.
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Sources and Attribution
- Charts (c) Money Mage https://www.moneymage.net/calculators/