Slicing the equity pie: Understanding shares, options, tax, and what even is a nominal value?
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The Cheat Sheet
- Shares vs. Options: Shares represent direct ownership in the company, granting rights to assets, earnings and voting. Options are contracts allowing the holder to purchase shares at a predetermined price in the future, often at a lower value. Shares are a tangible stake, while options offer future equity potential.
- Use Cases of Shares and Options: Shares are a straightforward way to raise capital and offer ownership, while options are commonly utilised to entice employees to stay invested in the company’s growth.
- Nominal Value: Nominal value represents the initial value assigned to a share during incorporation. It acts as the foundation for share pricing and determines the lowest price at which shares can be issued.
- Nominal Value and Market Value: While nominal value is a fixed anchor, market value is dynamic, influenced by market conditions and company performance. The difference between these values is the share premium.
- Overpricing and Downrounds: Overpricing shares can lead to uncomfortable situations, like a downround. This term refers to a situation where initial shareholders paid more for shares than their actual value, leading to losses and doubts about the company’s value or intentions.
- Underpricing: Issuing shares below market value might lead to a “benefit in kind” tax bill. Properly aligning the value of shares with their market worth can prevent undesirable tax surprises.
- Tax Approaches: “Approved” share schemes offer tax breaks based on differences between strike prices, AMVs and actual prices. To convince tax authorities like HMRC, you’ll need to provide evidence of how you arrived at these figures.
In the exhilarating world of start-ups, understanding equity is not just a sideline conversation – it’s a critical component that shapes the growth trajectory of your venture. You may be a wizard at coding, a savant in marketing, or a maestro of product development, but when it comes to the labyrinthine intricacies of start-up equity, even seasoned entrepreneurs can find themselves scratching their heads.
Think of your start-up as a pie, freshly baked and oozing with potential. You and your co-founders are the culinary artists who concocted this scrumptious creation. Initially, it’s easy to determine who gets a piece: the recipe creators, of course! But as you aim for higher success, the kitchen gets crowded. You find yourselves inviting investors and employees to partake in your dream, often trading slices of your precious pie for their time, skills, and financial backing.
The big question then becomes: How do you divide this pie fairly without short-changing anyone, including yourself? You want to offer slices that not only honour the value of your company today but also its future potential. Whether it’s through straightforward share ownership or the more complex realm of options, understanding the difference is crucial for allocating these slices wisely.
To help you make sense of this, let’s delve deeper into the fascinating yet complex world of shares and options.
Distributing Your Equity Pie: Shares vs. Options
When it comes to start-ups, there’s more than one way to slice the equity pie, and each method offers its own recipe for success. So, let’s grab our aprons and roll out the dough of understanding to explore the scrumptious world of equity. But firstly, did you know that a slice of apple pie costs £2.70 in Jamaica, and £3.50 in the Bahamas? These are the pie-rates of the Caribbean.
What Exactly Are Shares?
Now, let’s get back to business. Simply put, a share represents direct ownership in a company – a slice of the pie, if you will. If a company is divided into a million shares and you own a hundred of them, you essentially own 0.01% of the company. Owning shares gives you the right to a portion of the company’s assets and earnings. As importantly, and often not fully appreciated, it usually comes with voting rights, allowing you to have a say in company decisions.
So, What About Options?
Options, on the other hand, are slightly more complicated. An option is essentially a contract that gives you the ‘option’ to buy a share at a predetermined price, known as the strike price, within a specified period or on a certain event such as an exit (for example, if the company is listed on the stock market or is acquired by a larger business). Owning an option doesn’t mean you own a slice of the pie; it simply means you have the opportunity to buy shares at a future date, often at a price that could be much lower than the market value.
And What’s the Use Case?
Start-ups may issue shares for several reasons. Issuing shares can be a straightforward way to raise capital for the business. Investors know what they are getting, and shares can be valued easily based on market conditions or company financials. Additionally, shares can be sold or transferred with relative ease, making them a flexible form of investment.
On the flip side, options are a pie in the oven, promising, yet still cooking. Often used as a tool to attract and retain high-quality employees, they are designed to fill the room with an enticing aroma that lures talent and keeps them invested for the long term. What’s more, because start-ups often operate with limited dough – pun intended – offering options can be an effective way to motivate employees without affecting cash flow. When the company grows and increases in value, so does the value of the options, aligning the interests of the employees and the company.
Interested in diving deeper? Schedule a call with the Standard Ledger team to unlock further insights.
Pricing the Equity Pie: Essentials of Share Valuation
Let’s Get Nominal
Before you can issue shares or options, you’ll need to determine what you’re charging for a slice of the pie. Let’s start off with the concept of a nominal value. This is the value assigned to a share at the time your company is incorporated; the cost of the basic ingredients for your pie, without capturing the added value of your unique recipe or brand.
While this number is often set deliberately low (typically £0.01 or £1) it’s far from inconsequential. In legal terms, the nominal value represents the lowest price point at which you can issue a share. What’s more, nominal value is directly linked to your company’s share capital, which is calculated by multiplying the nominal value of each share by the total number of issued shares. For example, if a company has 1,000 shares with a nominal value of £1, it has a total share capital of £1,000.
What’s It Really Worth?
So, how does this have any influence on the share price you set, we hear you ask? The nominal value is a crucial component in calculating the share premium.
While nominal value acts as a static anchor, market value is the dynamic variable that captures investor sentiment and broader market forces. It’s the sum total of all the ingredients, the cooking process, and the brand value that makes your pie what it is. Imagine you have a share with a nominal value of £1, but current market conditions and company performance elevate investor willingness to pay up to £10 for that share. That gap – £9 in this case – represents the share premium.
In the earliest stages of a startup, the financial landscape is often a blank slate. Nominal value and market value start off on an equal footing, usually mirroring the initial price set for the shares. Let’s say you designate a nominal value of £1 per share when you create the startup; at this stage, the market value will also typically be £1, assuming no additional investments or valuations have been conducted. This scenario simplifies things considerably because you don’t have to wrestle with the complexities of differentiating between the two when pricing your shares.
However, as your startup matures, seeks external funding and achieves various milestones, the real-world market value of your shares – influenced by investor interest, company performance, and market dynamics – begins to separate from the nominal value.
The Price is Right
Previously, you could issue a share at its nominal value without a second thought. But as your market value rises, issuing shares at nominal value isn’t always sunshine and rainbows, and your share pricing strategy for fundraising, employee compensation, or any other form of equity distribution becomes a more nuanced endeavour.
Getting the price right matters, and there are three top things to be aware of so you can live apple-y (pie) ever after:
#1 Over Pricing: A Taste of Humble Pie
Picture your first funding round as a buffet, where investors eagerly dig into slices priced at £75 each. But as the next round arrives, reality serves up a different flavour – the slices now go for £65 each. This shift introduces you to the term “downround,” an experience no company relishes.
A downround means your initial shareholders bit off more than they could chew, paying above the pie’s actual value. This can lead to souring losses and a feeling of indulgence gone awry. This uncomfortable situation triggers questions and doubts, hinting that perhaps the company misjudged its own value or, worse, aimed to exploit unsuspecting investors. Just as a well-crafted pie strikes the right balance of flavours, your equity shares must reflect their true worth to avoid such unsavoury surprises.
#2 Feeding the Taxman: A Necessary Bite
Shares and options are ways of creating wealth for the holder, so when it comes to sharing slices of your equity pie, tax authorities, such as HMRC in the UK, certainly won’t miss their chance to have a nibble. This leads us to our second point. We’ve discussed the perils of overpricing, but what about underpricing?
Issuing shares below market value to reward employees may seem temptingly sweet at first, it can lead to a less-than-appetising situation. HMRC could categorise this as a “benefit in kind,” setting the stage for an unforeseen tax bill based on the actual market value.
Just as a skilled baker meticulously measures ingredients, ensuring your slice is correctly proportioned to its market value can make the difference between a buttery biscuit base and a metaphorical soggy bottom.
#3 Still Feeding the Taxman: A Pinch of Caution
Yes, getting the tax right really is that important, so it’s our third point too. After all, the taxman is always hungry.
In the UK, “approved” share schemes offer tax breaks based on the difference between the Strike Price (for Growth Shares and CSOPs) or AMV (Actual Market Value for EMI Shares), and the actual price achieved. But convincing HMRC isn’t as easy as simply sprinkling sugar on top (trust us, they know their pies) – you’ll need to provide proof of how you arrived at these figures.
For regular shares (not options), shareholders encounter capital gains tax on the difference between purchase and selling prices. The earlier someone acquires these shares in a company’s journey, typically the greater the potential difference between these two numbers. Latecomers to the feast miss out on these benefits, as they didn’t contribute to the growth before they joined.
However, any funny business in these numbers grants HMRC to investigate and recalibrate the tax bill – a financial taste-test, if you will. A foolproof tax recipe preserves both the crust, ahem, trust of investors and the reputation of your company.
In Summary: The Final Slice of Equity Pie
Let’s bring this culinary analogy full circle. When building a startup, the equity pie is a central element that requires careful slicing to ensure everyone gets a piece that reflects their contribution and keeps them invested in the venture. From determining the type of equity to distribute – be it shares or options – to understanding the financial and legal implications of each, it’s a complex but vital task. With a clear understanding of concepts like nominal value, market valuation and tax implications, you’re well-equipped to set the right price for each slice.
The journey through the world of startup equity might be intricate, but with the right knowledge and advisors at your side, you’re more than capable of making informed decisions. At Standard Ledger, we offer an array of specialised valuation services designed to be the secret ingredient in your startup’s success. Whether you’re kneading accurate start-up valuations for capital raising, crafting a delectable exit strategy, seeking HMRC-approved valuations for your Enterprise Management Incentive (EMI) scheme or determining the ‘hurdle’ rate for your growth shares, we’re here to satiate your valuation needs.
With our expert guidance, you’ll have all the ingredients to bake success into your startup’s journey. Get in touch with us today, and schedule a free call!
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