Those setting up an EMI Option for their key employees sometimes end up in a muddle over share buy-back rights.

The starting point for the confusion is that the business owner (and sometimes his inexperienced advisers) fail to distinguish between the two distinct phases of a scheme.  The first phase is the option period when the employee does not own shares but has a legal right to acquire their shares. The second phase is the period of share ownership after the employee has exercised his or her option.

Often it may be thought (rightly) that the employee is unlikely to exercise except at the point when the business owner is selling the company.  Indeed if the exercise price is a high one it may be out of the question for the employee to acquire shares except at that point.  It becomes a “back to back” exercise and sale-on.

But failing to think things through and understand the distinction can create a trap for the unwary business owner.  He is not advised perhaps as to whether he wants a share buy-back against the employee and if yes on what terms.

The owner may incorrectly conflate the lapse of an option if the employee leaves with such a buy‑back.  They are of course quite different.

Worse still the owner may not be advised to have his lawyers prepare new Articles (or perhaps a Shareholders’ Agreement) containing those provisions before the EMI option is granted.

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The EMI option must expressly refer to the buy-back in the Articles of Association or restrictions as the legislation rather confusingly calls them.  They should be copied and set out in the Option Agreement, failing which the option may not qualify for tax-advantaged EMI option treatment.

After the option has been granted the owner and his advisers may look to add a buy-back clause.  This may create an additional risk.

Suppose the accountants have applied to HMRC for a valuation and have argued for a lower price per share then a whole company valuation to reflect the fact that the shares represent a minority interest.  A discount of anything from 40% to 75% may be possible.

A long standing employee, however, may have been promised these shares effectively as a “free award”.  They may reflect service going back many years and be regarded by both employer and employee as effectively a gift.

The lawyer now charged with drafting the buy-back Article will, if he understands valuation methodologies, ask whether the buy-back Article should apply a per share value based on the whole company value.  The loyal employee may be disturbed to learn that the value of his shares, particularly where he has helped build significantly value from the date of the award, could be arbitrarily as he may see it, reduced in value by the accountant applying a discount of up to 75%.

The lawyer may simply use a standard draft set of Articles with pre-emption and buy-back.  These are likely to expressly exclude any minority discount as this is generally (but not always) the preferred provision where this is explained to the founder of a company.

The sting in the tail here is that the introduction of such a buy-back clause has arguably increased the value of the option shares.  This would constitute a disqualifying event:  the gain in value from that point in time would then be subject to income tax (or PAYE/NICs if the exercise is at the time of sale of the company) rather than CGT.

The moral of this story:  use an experienced share scheme adviser and make sure the scheme is fully thought through and documented on day one.

If it is not, when you come to sell your company the tax due diligence may lead to a nasty surprise for you and your unfortunate employee.

For a no obligation discussion about Employee Share Schemes or EMI Options, please contact us on 0845 868 0960 or email james.hunt@everymanlegal.com