Paying for something with nothing

Rob Carter explains a few things about share options before drilling down into the details of the Government’s new Enterprise Management Incentive.

Entrepreneurship is a process by which individuals – either on their own or inside organizations – pursue opportunities without regard to the resources they currently control.

This 23-year-old definition, coined by Howard H. Stevenson, who became a professor at Harvard before I was conceived, is now the standard for business schools around the world. It is neat and gets straight to the heart of what business founders are searching for: resources. In the main this means money.

You’d be forgiven for thinking that the sole purpose of a London start-up is to raise finance. Get funding. Do an A-round. Many seem to think that this is the end-game. Part of the reason we may have this impression is that current tech reporting seems to cover little besides funding rounds – which, of course, is ridiculous. The only sane reason for taking in investment is to get the company to a stage where it can sustain itself and its future growth.

It is before this comforting safety blanket of cash comes in that the entrepreneur has problems. How does he make his first “minimum viable product”without any money to pay a team? What resources does he have at his disposal? He has his vision; he knows this is going to be big some day. He “sells” this vision to someone else. Currently the shares in the business aren’t valuable. In fact, they are worthless. Worthless to almost everyone, except someone that shares the vision. To one who shares the vision these shares are a magic ticket to a future lined with wine cellars, yachts, Teslas and Mac Airs.

Giving shares to someone is a fairly permanent thing. If you can’t stand their T-shirts, coding, odour, aesthetics, politics, mouth-breathing or coke habit three months down the line then undoing this gift can be a tricky thing. On top of this the tax man has a particularly dim view of giving shares to someone. The tax man thinks that you are earning your shares. In fairness to him, you are using these shares as currency. But earning things means that you have to pay income tax on things.

It is now that our entrepreneur remembers that bit in that movie with that guy in and hits upon “stock options”. Stock options, or Share Options to give them their British name, are indeed a nifty solution for our hero. They can be tax efficient, meted out in line with dedication and performance and brilliantly, they can be withdrawn, or even automatically cease to exist, in the event of a falling out.

The important part about having options in a business that isn’t worth anything is that in order for the deal to deliver on its promise of iPads and Segways in the future the person has to play their part in making the vision happen. They are not incentivised on the current value of the options, they are incentivised on the future value of the options. Or specifically the shares that those options will become. Or, even more specifically, the money that those shares will become after they are options.

Last month some of the executives of RBS were forced, at mob-point, to refuse their contractual bonuses. These bonuses had been made in shares. You can buy four shares in RBS for about quid at the moment – in 2007 they were almost seven pounds each. Stephen Hester, CEO, had been incentivised not on the current value of those 3.6 million shares but on their future value, if he continued to do a good job. It was so obvious that this disincentivisation was a bad idea that hundreds of millions were wiped off the market capitalisation of RBS in a single morning, In fact the damage wasn’t contained to RBS: every UK bank got less valuable that day.

The market thought that not tying the staff into the future value of the business was in itself detrimental. The market decided that banking in general became a less valuable pursuit if government and press can force change in how staff in private companies are incentivised. As it happens, Hester is due another £600,000 worth of shares for a different part of his contractual bonus. For the time being, it appears that the pitchfork-wielders are looking a different way. If they stop Hester from being paid, he’s going to leave. And then no one will take the job and RBS could genuinely go under.

At least the angry mob currently have less interest in businesses that the UK taxpayer does not own 83 per cent of.

A Primer on EMI

With an Enterprise Management Incentive (EMI) scheme, qualifying employees in a qualifying company (“qualifying” is an HMRC word I have spoken about in these pages before) can have options granted to them. In this case, qualification is something that most employees in most normal start-ups should achieve with ease. This is not something a company should attempt without professional advice, though: it isn’t like copying another business’s T&C page, Find-Replacing the name and keeping your fingers crossed. A good solicitor should be able to provide the paperwork with change from few thousand pounds.

Options are literally the right, but not the obligation, to buy shares in a business at a pre-agreed price. An EMI scheme is a neat wrapper to enable both a mechanism for this as well as a tax benefit to the holder. As long as the UK business is worth less than £30m, less than £3m worth of shares are issued as options and each person is issued up to a maximum of £120,000 in options (any excess is specifically “non-qualifying”), then the employee has reduced his income tax and national insurance bill on any gains he makes to nil.

The employee will still pay capital gains tax (CGT) at 18 to 28 per cent, to the extent that the gain is above the minimum threshold. Although not publicly tested, it’s possible that should the individual’s share of the company be over 5 per cent then Entrepreneur’s Relief could kick in, bringing this down to a flat 10 per cent.

It’s sensible to establish a “proper” strike price, or valuation, for these shares and its best to have prior agreement with HMRC to avoid any surprises later. The valuation is at the date of the agreement and as such is normally at a fraction of what the business should be worth in the event of “exercise”, the moment you buy the shares.

In practice it is unlikely that the employee will actually buy the shares at all, certainly not to own for any length of time. The shares are only worth buying if they are going to be worth more than the strike price. This normally only happens in the event of the company being bought: the fabled exit. The separate transactions of buying and selling the shares becomes a single event for the option holder with the difference between the strike price and the acquisitor’s purchase price being funnelled directly to the employee.

Some Investor Advice

As a quick aside, you really should read a letter from the wonderful Shaun Usher at Letters of Note, written by Groucho Marx to the President of a company in which he had recently invested. While flippant and more than a little insulting, the message “Go easy with my money. I am in an extremely precarious profession whose livelihood depends upon a fickle public” is one of the best pieces of investor advice I’ve seen.

I think we are all in a profession whose livelihood depends on a fickle public aren’t we? I suspect Stephen Hester would agree.