The two main types of equity awards used by UK startups are share options and direct issues of shares.
A share option gives an employee the right to purchase a specified number of the company’s shares for a fixed price (the “exercise price”) during a prescribed period. The principal benefit of a share option is the potential to benefit from any increase in the value of the company’s shares during the period in which the option is exercisable, without risking any money. If the value of the shares increases above the exercise price during that period, the employee can acquire the shares at the exercise price (i.e. at a discount to the value of the shares) whereas if the value of the shares does not increase above the exercise price, the employee is under no obligation to acquire the shares. Companies have a good deal of flexibility when setting the commercial terms of share options and can specify restrictions on exercise (e.g. limiting it to exit events or making the options generally exercisable once vested) and vesting conditions (generally time-based but some companies specify performance-based conditions for senior employees).
Direct issues of shares can take different forms but the general tax position for directly issued shares is that the difference between the purchase price and the market value is taxable employment income for the recipient and, provided a section 431 election is signed and none of the relevant anti-avoidance provisions apply, any subsequent gain in value is subject to capital gains tax. Direct issues of shares can be tax-efficient if the shares subsequently increase in value although the initial outlay to acquire the shares means they are not risk-free for the recipient. One of the most common forms of direct share issue for startups is growth shares, which are a separate share class that only participate in the company’s growth in value above a set “hurdle”. This has the effect of reducing the upfront value (and cost to the recipient) of the growth share.
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