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How do Share Options and Sweat Equity Work?

How do Share Options and Sweat Equity Work?

1 months


Author: Sacha Bright, CEO Nextfin

Business owners and investors are often fixated on how much percentage of a company they own rather than what it's worth. Have you ever heard of the saying a smaller piece of a much bigger pie? The most successful entrepreneurs and investors in the world fully embrace this simple old adage. 

If any of your heroes are the likes of Branson, Zuckerburg, Musk, Gates, Jobs, or Bezos. Then you would do well to copy their adaption of equity to grow their businesses. You may be surprised to hear that all these leaders of industry have created millionaires in their businesses and in doing so have become billionaires building the largest businesses in the world. If you want to emulate even a smidgen of their success, then you need to understand the intricacies of using equity to develop & grow your business.

Share options and sweat equity is a proven way to help grow and create loyalty in a business. You can recruit board directors, contractors and high-level paid employees to work in return for shares. I recently advised a company to issue options to a contractor instead of cash, the owners refused, wanting to hold onto the equity and now the company has burnt all its cash and the equity has become worthless. Some of your biggest & most costly assets are the staff and contractors. Use the company equity to motivate them. Use of equity in this way not only instils a sense of ownership over the business from the stakeholder but in-turn increases the value of the business.  

Many business owners do not understand equity. I admit I didn't get it myself 10 years ago. It is the most under-educated area in business growth and funding.

How do share options work?

Share Options for staff 

Instruct a lawyer to set you up an approved government Enterprise Management Incentive (EMI) share option scheme. You can ask the lawyer to draw up contracts that require your staff to honour certain milestones before they are exercised. That could include service longevity or targets. For example: You set a Sales Director a target. Target: Increase sales from £1M to £10M within 2 years and receive £100k in shares at today’s issue value. The Sales Director achieves their target and in-turn increases the value of your business tenfold. The shares are now worth £1M. The best most elite Sales Directors understand these incentives and so should you if you want to recruit a world-class team.

Unapproved Share options for Non-executives or Contractors

A lawyer can create an unapproved share option scheme which usually works better in an early-stage company and the incentive works in much the same way as an approved scheme without the tax benefits.

Contractors and non-employed Directors cannot enter into EMI share option schemes. It's only meant for employees. The biggest issue here is that these shares may come with a tax liability when you issue them if they have a perceived value. My argument is that start-ups have no true value other than a future valuation when sold. The cash has to be deployed to create value.

The argument you are proposing to HMRC is that the recipient of the shares pays tax from £0 to what the shares are sold at upon exit. Whereas an EMI option scheme will come with tax benefits if you qualify. On a non-approved scheme HMRC will want to tax the recipient of the shares at the company's valuation when issued as a benefit and the recipient of those shares will need to prove that the shares have a zero value if they don't want a tax liability.

Example of an investment dilution and sweat equity deal

John Smith wants to expand his online Vegan recipe business. He has built the website software and created the recipes and he needs £30K to expand. He feels the business is worth pre-investment £100K because he has already invested £50K and has valued his time and intellectual property (IP) at £50K. Peter would like to invest in John and without him, at this stage, the business has little or no value. So, the investment is all about John.

 

Investing in Vegan recipes business

Pre-money valuation £100K 

John owns 100 shares at £1000 per share

Peter has agreed to invest £30K

He now needs to issue 30 shares at £1000 per share to accept Peters investment

The total amount of shares in issue post-investment is now 130

Peter now owns 23% valued at £30k

John now owns 77% valued at £100k

Total post-investment value is £130k

 

The biggest misunderstanding founders make is they think they are going to be diluted by 30% in this scenario and this is not the case. John has been diluted by 23% and he has issued more shares.  

Sweat equity

This also applies to sweat equity. John would like to recruit Peter a famous Vegan Chef but he would like to keep his cash to expand the business so he offers him shares. He offers him £30K worth of shares for sweat equity. In doing this John is creating more value in his company. The company is now worth £160K. It is also more valuable because the company is no longer all about John. It now has key personnel with a vested interest in the success of the business, thus making the business more investible.  

Issuing shares for cash in a start-up

When issuing shares for cash you need a valuation of the start-up. This is usually pitched by the entrepreneur and then negotiated with a lead investor. There are still many options here for both the investor and the entrepreneur. A shareholder’s agreement can have many elements to it, including, targets and options for the founder to increase his shareholding if he/she increases the valuation of the business. Ask a lawyer what type of elements can be included but be creative. If there is a win-win to be had write it into the agreement.

Disclaimer: You cannot rely on this article for tax advice, it is meant as a guide only. Although every effort has been made to ensure the information is correct at the date of publication, your circumstances and the legislation may have changed. Please seek independent professional advice.



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