Can you amend employee share options?

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.

Seeking to amend an employee share scheme potentially creates 2 significant legal and practical problems. Firstly, is it legal to unilaterally seek to change the terms of employee shares or options and how will the employee react? Secondly, there may be issues with tax under the HMRC tax advantaged options.

We advise employers who have employee share schemes and also employees who need advice where the employer either claims the options are no longer valid or otherwise seek to change the terms previously offered and agreed.

Why amend the terms of an employee share 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.
• Employee leavers – 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.
• Change of control – 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.
• Share Capital changes – 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 share 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 employee share options

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 under an existing term of the scheme 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

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.

To discuss this with our employee share plan team, please call on 020 7438 1060.