We work with employers often before an exit to review option awards and recommend amendments.
HMRC operates an approval system for employers which is helpful as it provides certainty. We craft applications to fit within HMRC policies to improve the chances of success.
Businesses grow and develop bringing the need to make amendments to existing share options awarded to employees. We take a look at what changes can be made and how. Amendments to HMRC tax advantaged options can cause problems – but we look to find any ways around the problem.
Why amend the terms of an option grant.
Based on practical experience we find the most typical reasons for making amendments to options include:
- Performance conditions attached to the ability to exercise the options are no longer capable of being achieved. Often the targets set were too ambitious or the introduction of new business lines has made the targets meaningless.
- A clause is drafted into the option agreement which allows the options to lapse when the employee ceases to be employed. However, an employer may wish to allow such a person to retain his options.
- The option is under water. Underwater options are options where the exercise price is higher than the current value of shares under option. Totally demotivating.
- There has been a change of control and the new owners want to replace the existing options over shares in the seller with shares in the new owners – i.e. roll over the option. Some plans allow for roll over but if this ability is missing a change to the terms will be required.
- Employers wish to amend the number of shares which are under option or the exercise price of the options to reflect changes in the share capital.
- The articles and or shareholders agreement require amendment which will impact on the shares issued under option. For example, when the options were granted the company adopted the standard articles provided upon incorporation. The original articles are now found to be deficient because for example they do not require leavers to sell their shares if the employment or directorship is terminated. Another common deficiency with standard articles is the lack of drag and tag rights which can make it difficult to sell the entire company – i.e. “exit”.
How to implement option changes
When considering what changes can be implemented and how to implement the changes you need to look at the general position and then the type of option as the rules are different. Options split broadly into two types and the process is very different:
- Non-tax-advantaged options
- Tax advantaged options of which a very common type are EMI options
General rules on amending options held by employees
The option agreement is a contract and usually, as with any contract, it can only be amended with consent of both parties. However, the consent of the option holder may not need to be given if, for example, the amendment is allowed by operating an existing term of the agreement. Whether shareholder approval is required depends on the articles of association, any shareholders’ agreements in place or, if shareholder approval was required to set the plan, whether approval is required to amend the terms.
If an employer is able to amend the terms of the options and wishes to do so then it is important that these changes are documented clearly, with board minutes, usually in a written agreement and usually by deed (as consideration is unlikely to be given for the amendment). Some changes will even require a notification to HMRC so it is important that an employer knows what is required in advance of making the required changes.
Check the plan rules
The first step when contemplating changes to an existing option agreement is to check the plan rules and/or the share option agreement to see whether there is an existing provision which allows for the employer to amend the terms. Often the documentation will provide that employee consent is required to any amendments. Board and shareholder consent can also be a requirement.
Non-tax-advantaged options (formerly ‘unapproved’ options) are not governed by any particular legislative rules which would restrict the power to amend an option. Therefore, with the consent of the option holder and the employer terms can usually be changed easily. If the change was a cancellation of existing options and a re-grant of new options the details would be reported on the annual online ERS (employment related securities) tax return. If the non-tax-advantaged continues albeit subject to amendment there is no need to report the change to HMRC.
Tax advantaged options
The risk is that HMRC may view an amendment to the terms of a tax advantaged option (such as an EMI option) to be the grant of a new option. If there is a grant of a new option there has to be a new calculation of the tax market value of the shares under option. If the business has performed well and HMRC can point to an increase in the tax market value of the shares under option the result is the employee may have a larger tax charge than originally calculated. The fact that the share option plan rules permit amendment does not mean that HMRC will continue to afford the tax advantaged status. If this occurs on or close to an “exit” e.g. on a sale of the company, there will be tax consequences for the employer company too in the form of employer NICs. Dependent on the size of the liability this may protract negotiations for sale and require various protections to be put in place by the buyer.
HMRC has very strict rules which prevent most amendments to options once granted. For example, subject to limited exceptions, amendments to deal with the reasons mentioned above such as under water options, changes to the share capital and amending the performance targets are not permitted to tax advantaged options. If amendments are made without HMRC approval the tax status will be invalidated. The clock for capital gains tax treatment for entrepreneurs’ relief may well be restarted too if HMRC deem a new option has been granted.
- A small private company with model articles adopted on incorporation granted options to 5 of its key members of staff 6 years ago. The options are “exit only” EMI options which means the options can only be exercised upon an exit. The founders and the option holders hold the same class of shares. The company has traded successfully and the founders are now getting ready to exit. The founders have found a third party looking to acquire 100% of the share capital. The potential buyer is concerned that it cannot guarantee acquisition of 100% of the equity as the option holders cannot be forced to sell the shares acquired on exercise of their EMI options. The buyer wants to offer different levels of consideration to founders and option holders. The buyer wants an earn out incorporated into the consideration paid to founders but not other shareholders. This is not an unusual situation.
In this situation it is likely that if the company applied to HMRC for clearance it would obtain approval to the amendment to the articles dealing with drag rights. With HMRC approval the tax status is preserved. However, in order to pay deferred consideration to founders but not the employee shareholders acquiring shares upon an exit there would have to be a change to the share classes. Any change to the ordinary shares under EMI option would not be permitted. It is possible that the class of shares held by founders could be changed but depending upon the facts there may be other tax issues which arise. The best recommendation is to look at the position well before the exit arrives as by exit stage it could be too late to implement changes and the underlying value of the shares upon which any tax is calculated will have increased.
Catherine Ramsay is a partner specialising in employee share plans. There are many surveys and statistics which show that companies with employee share plans in place out perform those without. We implement a wide range of solutions for a wide range of business needs. To discuss this with our employee share plan team, please call on 020 7438 1060.
Manages to explain difficult concepts in easy to understand language. In tune with her clients.