Share options – structuring incentives for growth

For early-stage companies looking to attract and retain top talent, share options are a critical tool. They allow companies to offer equity to employees, advisors, and other contributors, aligning their interests with the long-term success of the business. 

Share options are also a key focus in venture capital term sheets, as investors want to ensure the company has a robust incentive structure without diluting their investment unfairly.

This article delves into the mechanics of share options, their impact on the cap table, and the considerations for both founders and investors. As part of our "Anatomy of a term sheet" series, we’ll also explore the differences between pre- and post-investment option pools and provide practical insights into negotiating share option provisions.

What are share options?

Share options give recipients the right to buy shares in the company at a predetermined price (the exercise price) after meeting certain conditions, such as a vesting schedule. This allows employees and other stakeholders to share in the company’s growth, incentivising them to contribute to its success.

Key features of share options include:

• Exercise price: usually set at the fair market value of the shares at the time the option is granted.
• Vesting: the process by which the right to exercise options is earned over time, typically tied to continued service or performance milestones.
• Option pool: the number of shares set aside for issuance under the company’s share option scheme, typically expressed as a percentage of the fully diluted share capital.

Pre-investment vs post-investment option pools

A common point of negotiation between founders and investors is whether the option pool is created or increased pre-investment or post-investment. The timing significantly affects founder dilution and is often referred to as the option pool shuffle.

Pre-investment option pool

Investors typically insist that the option pool is created or expanded before their investment. This means that the dilution caused by the option pool comes entirely out of the founders’ equity, effectively reducing the company’s pre-money valuation.

Post-investment option pool

If the option pool is created after the investment, the dilution is shared proportionally by all shareholders, including the new investor. This approach is more founder-friendly but less common unless strongly negotiated.

Structuring a share option scheme

The share option scheme should be carefully designed to meet the company’s needs while balancing compliance with tax-efficient schemes such as the Enterprise Management Incentive (EMI) in the UK.

Key considerations

• Size of the option pool:
  • Early-stage companies typically set aside 10–15% of the fully diluted share capital.
  • This may increase in later funding rounds if additional options are required to attract senior hires.
• Vesting schedules:
  • Standard vesting schedules are four years with a one-year cliff (e.g., no options vest in the first year, after which 25% vest, followed by monthly or quarterly vesting).
  • Performance-based vesting can also be used to align incentives with specific milestones.
• Leaver provisions:
  • Ensure that unvested options lapse when an employee leaves the company.
  • Companies often include provisions for good leavers (who may retain some vested options) and bad leavers (who forfeit all options).
• Tax efficiency:
  • Emi schemes allow qualifying employees to benefit from lower income tax and capital gains tax rates.
  • Non-qualifying schemes may result in higher tax liabilities, making them less attractive.

Impact of share options on the cap table

Share options directly affect the company’s fully diluted share capital, which includes all issued shares and shares that could be issued under option schemes. When issuing new shares to option holders, existing shareholders are diluted.

Investors will typically request a pre- and post-investment cap table in the term sheet to visualise how the option pool and subsequent investments impact shareholdings.

Negotiation strategies

For founders:

• Push for a post-investment option pool: this ensures dilution is shared with investors, preserving founder equity.
• Limit pool size: avoid over-allocating shares to the option pool—an excessive pool reduces founder ownership unnecessarily.
• Optimise tax efficiency: ensure the scheme qualifies for EMI or similar tax benefits.

For investors:

• Insist on a pre-investment option pool: this protects the investor’s ownership percentage and ensures the company has sufficient equity to attract top talent.
• Review leaver provisions: ensure that options are structured to incentivise retention and align with long-term goals.

Analysis: founders’ perspective vs investors’ perspective 

In summary

Share options are a powerful tool for aligning the interests of employees, founders, and investors. However, they require careful structuring and negotiation to ensure they achieve their purpose without disproportionately diluting key stakeholders. 

By understanding the mechanics of share options and negotiating strategically, founders can preserve their equity, while maintaining flexibility to grow their team.

Read the next article in our "Anatomy of a term sheet" series, tackling Anti-Dilution Protections, exploring how they protect investors during down rounds and their implications for founders. 

If you're navigating the complexities of venture capital term sheets or preparing your business for investment, our experienced team is here to help. Get in touch to discuss how we can support you in securing the right deal for your business.