An increasingly popular term in the small business world, share options still remain a confusing topic for some. Whether it’s a solid definition of the phrase or their benefits, share options might seem a little baffling, especially since they’re distinct from shares themselves.
If you’re a start-up or SME, share options can be a great way to attract and incentivise key employees or directors, as well as preserve those all-important cash reserves. In this beginner’s guide, we’ll clear up the confusion surrounding share options, their advantages and disadvantages, and where they might be a good fit for your business.
Share options are essentially an agreement between employee and employer to buy shares at a pre-determined price. An employee can strike a deal so they can buy shares at their current value, but defer the transaction for a number of years. Imagine if you were to buy something in five years’ time at the price of what it costs rights now. That item is likely to be more expensive in five years’ time (due to inflation and other factors), so it’s a comparative bargain for employees who take advantage of them.
The offering price, known as the grant price, is typically the market price at the time the option is offered. The employee can purchase the option when he or she wants to within a set period of time. If the stock has gone up, they can then purchase the shares at the original grant price and either sell them for a profit or hold onto the shares in hope that the stock will continue to gain.
There are many different reasons why share options might be offered. Consider the outset of a start-up; they’ll probably have limited money at the beginning. Offering share options is a way of attracting top employees who will then increase profitability for the business as a whole. This equity, in the form of share options, lets start-ups retain their most talented employees over time.
On top of that, the payments offered by share options is tax-efficient, helping to reduce employment costs. In addition, they can help align the interests of senior executives with those of shareholders by encouraging them to consider the shareholders’ interests in managing the business.
As well as holding onto your top talent, there are other benefits to offering share options. The offer of buying share options can motivate employees to become more productive, especially if you need to compensate for lower salaries and relieve pressure on cashflow.
While the company founders are the true owners, share options encourage an ownership mentality amongst the team. This allows everyone to rally the whole team around a single mission. By allowing employees to take an active role in how the company is run, everyone feels more responsible, fostering a sense of commitment and a long-term mindset in the process.
As for disadvantages, there is an inherent financial risk to share options. If the company offers stock at too low a price because it simply isn’t valuable, the employee is free to choose not to purchase the stock. However, upon purchasing the stock and it plummets, then there’s a risk of losing money. The lost income via the stock might mean an employee has to work longer hours or take a second job.
Similarly, if employees buy into share options then businesses must issue more shares of stock. The extra shares of stock dilute these earnings per share, making each share of stock worth less than it was before. The combination of lots of employees purchasing stock and an unstable equity structure can pose a risk. This may mean the company has to repurchase stock or find a way to increase its earnings as a result.
In terms of incentivising employees, share options are only effective when the price of the share has increased. Employees may feel less motivated if their future finances only depend on the success of the company.
If your business has big plans, already has some investment in place and a team of people who you want to offer shares to, a share option plan or another method of issuing shares could be suitable.
That said, you have to think about whether they’ll want to, and if this offer is truly to their advantage. It might look good on paper, but you shouldn’t always assume it’s what’s right for your company.
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When choosing between the various share options, there are a number of things to consider:
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