When the employee exercises the EMI option, they pay the discounted value (calculated at the date of grant) and could eventually pay capital gains taxes on the whole of the increase in value.
In summary, while the employee may be paying an approved market value meaning that any increase is efficiently taxed, the actual market value on day one could in real terms be higher, meaning that the employee does receive value on grant.
Ultimately with less tax to pay, the employer (and ultimately the existing shareholders) can give less away to achieve the same post tax paid outcome. The difference can be surprising.
There are some restrictions meaning that not every business will qualify, nor are EMI options available to certain employees or non-employed consultants.
In these instances, businesses should think more inventively, or accept the risk that tax is likely to be paid on a higher basis.
Unapproved share option
An unapproved share option (which can be granted by companies to most employees and non-employed consultants) is seen as a tax inefficient arrangement as any gain until such time as the option was exercised could fall within the realms of income taxes. However, it may still be worth considering an unapproved share option if no other options are available.
From a commercial perspective, a key attraction of an option based share incentive is that they are just an option, and if the option is never exercised then the holder does not own shares.
On that basis, until the option is exercised, the holder will not actually hold shares, meaning they hold limited shareholder rights and the day to day running of the business would not change.
Trigger events for exercise of the option are important, and many companies opt for an exit only option meaning that it can only be exercised as part of a sale of the whole.
Clearly this may be inappropriate if the business model is such that an exit is not going to be achieved in the near to medium term, in which case trigger events for exercise can be linked to time and/or performance criteria.
The concept of vesting is commonly used. This essentially guarantees options once vesting criteria have been met.
This could mean that if an employee is disqualified from exercising the option, they can still exercise the vested proportion into shares.
Options are also hugely flexible as they can be crafted to maximise the incentive while protecting the business against future events.