How to exercise share options

Step 1: Option Holder - Check Exercise Conditions

The option holder should review the terms outlined in their option agreement to determine when they are eligible to exercise. This could be based on a time period, performance conditions, or a specific event (e.g., sale of the company).

Step 2: Company - Check Pre-Emption Rights

Pre-emption rights give existing shareholders the first right to purchase new shares before they are offered to others. These rights aim to prevent dilution of existing shareholdings and maintain control within the current shareholder group.

If pre-emption rights apply, the company may need to offer the shares to existing shareholders first before issuing them to the option holder. This could delay or block the exercise process.

Review the company’s articles and agreements to see if pre-emption rights need to be waived. Shareholders may need to provide written consent before the shares can be issued to the option holder.

Step 3: Option Holder - Notify the Company

Option holders must formally notify the company of their intention to exercise their options. The company may require a written exercise notice.

Step 4: Company - Check Exercise Timeframe

EMI options must be exercised within 10 years of the grant. If an employee leaves, they typically have 90 days to exercise, or the options lose their tax advantages. Some agreements may allow longer periods, but tax benefits are lost after 90 days.

Unapproved options have no legal time limit, but the company sets its own rules. Leavers often have 30-90 days to exercise, or the options lapse. Exercise may also be tied to an exit event (e.g. company sale or IPO).

Step 5: Company - Obtain Board Approval

Board approval is not always required for share options to be exercised so it can depend on the specific terms of the option agreement and the company’s governance structure. The company should check its articles of association and shareholder agreement to identify whether board approval is required prior to the shares being issed.

Step 6: Option Holder - Pay the Exercise Price

The option holder pays the predetermined exercise price for the shares, as outlined in the option agreement. The company should verify that the payment has been received and update its accounting system accordingly.

Step 7: Option Holder - Sign onto the Shareholder Agreement

The option holder may need to sign onto a shareholder agreement when they exercise their options and become a shareholder. This ensures they are bound by the same rights and obligations as existing shareholders.

The option holder will need to sign a Deed of Adherence, a short legal document confirming they agree to the existing shareholders' agreement terms.

Step 8: Company - Issue and Register Shares

Upon receipt of payment, the company issues shares to the option holder and updates the company’s register of members. Share certificates may also be issued.

It is important for the company to check the type of share to be issued, and if this is a new share class, that the current articles of association allow for the creation of a new share class.

Step 9: Option Holder - Consider Tax Implications

EMI Options

If the exercise price is at least the market value of the shares at the time of the grant, no Income Tax or National Insurance Contributions (NICs) are due at exercise.
If the exercise price is below market value, the difference between the exercise price and the market value at the grant is subject to Income Tax. The option holder may want to consider making a Section 431 election.

Unapproved Options

Income Tax is due on the difference between the exercise price and the market value of the shares at exercise.
If the shares are readily convertible assets (RCAs) (e.g. in a company about to be sold), NICs may also apply.

Section 431 Election

A Section 431 (s431) election is an agreement between an option holder and company to ignore any restrictions on shares acquired through an option exercise for tax purposes. This applies when employees acquire restricted securities, such as EMI or unapproved shares, to prevent higher Income Tax charges in the future.

The benefit of a s431 election is that Income Tax is based on the full unrestricted market value (UMV) at acquisition, avoiding future tax on any increase in value when restrictions lift.

This avoids 'dry' tax charges as it prevents unexpected tax bills if restrictions lift and increase the taxable value later. It also ensures future gains are taxed under Capital Gains Tax (CGT) which typically is at lower rates rather than Income Tax.

A signed election must be submitted within 14 days of acquiring the shares to be valid.

Step 9: Company - Report to HMRC

The company must report the exercise of EMI options to HMRC through the ERS (Employment Related Securities) return by 6th July following the tax year in which the options were exercised.