Restrictions on EMI share options and why they matter

Ruby Liptak
March 1, 2023

This blog will briefly give a practical overview of how your company can consider what restrictions you need to include when preparing your EMI Option Agreement and why it matters.

With over 84% of companies offering tax-advantage options in the UK, the popularity and effectiveness of EMI Scheme options is unquestionable. So, now that you’ve determined your eligibility to set up an EMI Scheme, established the plan rules, and set up the templates on Cake you’re probably thinking ‘I’m ready to send out my first offer - is there anything else I need to think about?’ Yes!

Under Schedule 5 of the Income Tax (Earnings and Pensions) Act 2003 (‘ITEPA’), one of the key conditions for the offer to be considered a valid EMI offer, and so recipients can benefit from the tax advantages, is that the Option Agreement, or a secondary document (together, the ‘Relevant Documents’) (eg. the companies’ Articles of Association, scheme rules, or Shareholders Agreement), must explicitly state the details of all restrictions on the options. But what is a restriction? And where do I include them in the Option Agreement?

Defining what constitutes a ‘restriction’ is a little tricky, however, correctly describing the correct restrictions of the EMI Scheme is crucial for compliance purposes of HMRC’s Employee Tax Advantaged Share Scheme User Manual (‘ETASSUM’). Luckily for you, we’ve waded through the legislation and spoken to our trusted legal startup experts to boil it down to a simple bite-sized blog.

So, what is a ‘restriction’?

Restrictions are any conditions set on the underlying security that prevent the share/option holder from enjoying the rights of the shares. They differ from share class characteristics which describe the rights attached to the shares themselves.

An example of a restriction are ‘Drag-along rights’. This is a type of restriction where minority shareholders can be forced to sell their shares, along with the majority, in a liquidity event - therefore, curtailing enjoyment of the shares. By contrast, an example of a share class characteristic may be that they don’t hold any voting rights. Here, there is no right or particular impediment to the free use or enjoyment of the share.

The details of the restrictions on shares are drafted into the Option Agreements so that the underlying securities are deemed ‘restricted securities’ for the purpose of section 423 of the ITEPA.

Examples of ‘Restrictions’

Some examples of what constitutes a restriction include:

  • Restrictions on the transfer of options
  • Any compulsory transfer provisions
  • Right of first refusal - where shareholders are not allowed to transfer shares without offering them to existing shareholders first
  • Tag-along: minority shareholders can tag along to get the same deal terms as major shareholders in a sale
  • Co-Sale: must give other shareholders the right to sell alongside yours
  • Board discretion: the board can refuse to register the transfer of shares
  • Deed of adherence: not allowed to sell shares unless the buyer signs on to the last Shareholder Agreement
  • Compulsory transfer of shares back to the company in case of bankruptcy
  • Compulsory transfer of shares back to the company when employment ends, even if the person is not a Bad Leaver

IN OTHER WORDS… Any restrictions that apply to the options must be included within the Relevant Documents.

What happens if the restrictions are not correctly incorporated?

In the case that restrictions are left out from grant documentation, HMRC will take into consideration any evidence that the restrictions have been otherwise brought to a Participant’s attention in a meaningful way at or near the date of option grant. However, if there is a failure to state these restrictions, the option offer may be considered non-compliant. This may disqualify the options from being treated as EMI options, and the recipient may not reap the tax benefits of the scheme!

For further guidance we have an amazing team of legal partners who are startup focused and can further assist you in your queries - just click here, and we will handle the rest!

Ruby Liptak

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