Among the best ways to share ownership with your team in the UK is through a share option scheme.
Options are essentially a future promise of shares in the event that certain conditions are met.
To give your team options, you first need to create an option pool. This doesn’t create new shares at this point, but it does put in place the formal company structure under which options can be granted now and the shares issued in due course when the options are exercised.
In this article, we will go through the steps that founders should follow to create and use an option pool, highlighting some important considerations to make along the way.
What is an option pool?
So, first things first: What is an option pool?
An option pool is an approved allocation of a private company’s equity that is reserved for your employee share option scheme. In the UK there are two scheme types to choose from: Unapproved Options or the Enterprise Management Incentive (EMI) scheme.
Options are especially effective as, unlike ordinary shares, they allow for a level of conditionality to be attached to them. When a new member joins your team, conditions can be put in place that need to be met in order for them to receive the full allocation of their options.
Usually this is a milestone - either length-of-service or performance related.
In the event that these conditions aren’t met, some or all of their options lapse. This stops people from walking away with shares without having delivered on their promises.
An option pool, therefore, is the potential for equity that is kept ring fenced to deliver on these future promises, should the agreed conditions be met.
How do you create an option pool?
The process of creating an option pool is actually quite straightforward.
In order to be able to authorise your option pool there are a number of simple steps that you should follow:
1. Decide which shares to issue over
Once you know how many shares you want to issue options over, you need to decide whether you will issue options over new or existing shares. Here you have three options:
- To issue over new shares (which is the most common case)
- To issue over a specific individuals’ existing shares
- To issue over treasury shares.
2. Ensure liquidity
Now that you know how many shares and the nature of the shares that you wish to issue options over, you need to understand whether the shares are suitably liquid. When a company is founded, it can often have as few as ten or a hundred shares.
Therefore, in many cases, it may be desirable to subdivide existing shares into thousands, or even a million, in order to provide liquidity for your option pool. This means that you can give relatively small percentages of equity to people but it will feel “meaningful”.
3. Choose a share class
The next step is to choose which share class you want to issue options over. Do you want to issue over an existing share class, or do you want to create a new share class?
The latter might be desirable if you want your option pool to be issued over non-voting or non-dividend paying shares, however this is not an issue if your scheme is going to be exit-only rather than exercisable.
4. Decide your option pool size
Now you are ready to decide how big you want your option pool to be. What percentage of your total equity do you want to allocate to your pool?
On the whole, somewhere between 5% and 15% of a company’s total equity is a normal option pool size. This is entirely up to the founder, and is an important business decision, which will likely be driven by whether you are issuing options to co-founders or to employees more broadly.
5. Future-proof your option pool
At this stage, it is worth deciding whether you just need the option pool for now, or whether you want to set it up to cover the next few years.
The reason this is important is because of the shareholder resolutions that you will need to pass in order to create your share scheme. If you are likely to issue more options in the near future, it is worth creating your pool so that it will cover the next few years, which saves you the hassle of bothering shareholders to sign another resolution.
Once this is decided, you are ready to get formal authorisation from the Board and existing shareholders through formal company resolutions. In this step, you are asking for authorisation to:
- Create the scheme
- Issue options over the number of shares you have decided
- Wave existing shareholders pre-emption rights over these shares.
The last point is important, as you don’t want new options losing shares down the line as a result of existing shareholders’ pre-emption rights. This can get messy.
Option pools: Only the first step
At this stage it is important to note that creating an option pool is not the same as creating a share scheme - it is merely the first step. Think of your share scheme as the river, with the option pool being the source.
This is an important distinction, as the two concepts are often confused.
Once your option pool is ready you can get things flowing and design your scheme and obtain an up-to-date company valuation, before inviting recipients to join, and notifying HMRC.
If you would like to get your option pool sorted, then it is worth booking in a free consultation with one of our equity experts. We have helped thousands of founders to navigate the complexities of managing their equity, and we’d love to help you.