IFRS 2 for UK startups: practical guide to EMI option valuation and accounting

Understanding IFRS 2: The Core Principle for UK Startups

For UK startups, granting equity through schemes like EMI options is a powerful tool for attracting talent when cash is tight. You might start by tracking your cap table on a simple spreadsheet, but it grows more complex with each new hire. The trigger for formalising this process is often the first financial audit or a due diligence request from a potential investor. Suddenly, a term you may have never heard before appears: IFRS 2. This isn't just an accounting formality; it is a required standard for presenting your financial health accurately. Understanding how to account for EMI options under IFRS 2 is a crucial step in scaling your finance function from a cash-in, cash-out view to a professional, auditable set of accounts that gives investors confidence.

At its heart, IFRS 2 is the global accounting standard governing share-based payments. The core principle is that payments made to employees in the form of equity must be recognised as an expense. Think of it this way: if you had paid an employee in cash instead of options, it would have been an obvious expense on your Profit and Loss (P&L) statement. IFRS 2 ensures that granting valuable equity is treated with the same financial gravity, aligning with the accruals concept of accounting where expenses are matched to the period in which the service is received.

This expense is not the price the employee pays to exercise their options, known as the strike price. Instead, the expense is based on the 'fair value' of the option at the grant date, representing the theoretical worth of the option itself. Crucially, this total value is expensed over the vesting period, not all at once. This process matches the expense to the period over which the employee provides their services to earn those options, giving a truer picture of your company's performance over time. IFRS 2 applies to all equity-settled awards, such as EMI options, where the company fulfils the obligation by issuing shares.

How to Account for EMI Options Under IFRS 2: A Step-by-Step Guide

Navigating the requirements can seem complex, but breaking it down into a clear process makes it manageable. For most early-stage UK companies, compliance involves three distinct stages: valuing the options correctly, recording the expense in your accounts, and maintaining ongoing alignment between your records and reality.

Step 1: Correctly Valuing Your EMI Options

The first and most common challenge is putting a credible monetary value on the options you grant. This is not as simple as using the exercise price. For financial reporting, you need to calculate a separate 'fair value' specifically for IFRS 2 purposes. This process requires a specific methodology and a clear understanding of the difference between tax valuations and financial reporting valuations.

Why Your HMRC Valuation is Not Your IFRS 2 Valuation

Many startups first encounter formal valuations when setting up a tax-advantaged EMI scheme. For this, you will agree upon a valuation with HMRC, typically comprising an Actual Market Value (AMV) and an Unrestricted Market Value (UMV). These valuations are specifically for tax purposes. However, the 'Fair Value' required by IFRS 2 is for financial reporting and is almost always significantly higher than the HMRC valuation. It is a common but significant mistake to use your HMRC valuation for your financial accounts. In day-to-day finance operations, what actually happens is that auditors will reject the use of an HMRC valuation for IFRS 2 expensing because it does not account for the full economic value of the option itself.

Using the Black-Scholes Model for Fair Value Calculation

So, how do you calculate this IFRS 2 fair value? The Black-Scholes model is the industry standard for option valuation, used by over 95% of venture-backed UK startups. It is a mathematical model that calculates the theoretical value of options based on several key inputs. While the formula is complex, your responsibility is to understand and correctly source the inputs to ensure the final valuation is defensible under audit scrutiny.

A Breakdown of Black-Scholes Inputs

Accurately sourcing these inputs is the key to producing a valuation that will stand up to an audit. Here is a breakdown of what they mean and where to find them for a private UK startup:

• Share Price: This is the value of one ordinary share on the date the option is granted. The most common and defensible source is the price per share from your most recent funding round. If your last round was more than a year ago, you may need to perform a more recent valuation.
• Exercise Price: This is the price the employee will pay to purchase a share. It is set in the option agreement and is often aligned with the AMV from the HMRC valuation.
• Expected Volatility: This measures how much the company’s share price is expected to fluctuate. Since private companies have no trading history, this is one of the most difficult inputs to determine. Expected volatility for private companies is often based on the historical volatility of a group of comparable publicly traded companies in your sector.
• Time to Expiry: This represents the lifespan of the option. For most UK schemes, this is typically 10 years, as defined in the option agreement. Sometimes, a shorter 'expected life' is used if data suggests employees tend to exercise or leave much sooner, but using the full contractual term is common for startups.
• Risk-Free Rate: This is the theoretical rate of return of an investment with zero risk. The source for the risk-free rate is typically UK Government Gilt yields matching the option's time to expiry, available from the Bank of England website.
• Dividend Yield: This is the expected dividend payment as a percentage of the share price. For the vast majority of growing UK startups, which reinvest profits for growth, the dividend yield is 0%.

Step 2: Recording the Share-Based Payment Expense

Once you have the total fair value for a batch of granted options, the next step is to translate it into the correct accounting entries. The total value is recognised gradually over the vesting period. For a typical four-year vesting schedule with a one-year cliff, no expense is recorded in the first year. After the one-year cliff is met, you would book 1/4 of the total expense. The remaining amount is then recognised evenly, usually on a monthly or quarterly basis, over the next three years.

The Journal Entries Explained

The standard journal entry is a Debit to 'Share-Based Payment Expense' (an account on the P&L) and a Credit to 'Share-Based Payment Reserve' (an equity account on the Balance Sheet). This correctly reflects the cost as an operational expense, reducing your reported profit, while also increasing your total equity to reflect the future claim on shares. For detailed guidance, the KPMG Share-Based Payment Handbook provides practical journal entry examples.

Example: Standard Monthly Expense
A UK SaaS startup grants options with a total IFRS 2 fair value of £48,000 that vest over four years. The annual expense is £12,000 (£48,000 / 4), and the monthly expense is £1,000.

In accounting software like Xero, the manual journal entry each month would be:

• Debit: Share-Based Payment Expense (P&L Account) - £1,000
• Credit: Share-Based Payment Reserve (Equity Account) - £1,000

Accounting for Leavers and Forfeitures

What happens when an employee leaves before their options are fully vested? This is called a forfeiture. When this occurs, you must reverse the expense that has been recognised to date for that specific employee's unvested options. IFRS 2 technically requires companies to estimate a forfeiture rate upfront, but in practice, most startups simply adjust for actual leavers as they occur.

Example: Reversing an Expense for a Leaver
An employee from the same SaaS startup leaves 18 months into their grant. You have already expensed £18,000 for their options (£1,000 x 18 months). Since they left before the options were fully earned, all of that recognised expense must be reversed.

The journal entry in Xero would be:

• Debit: Share-Based Payment Reserve (Equity Account) - £18,000
• Credit: Share-Based Payment Expense (P&L Account) - £18,000

This reversal correctly adjusts both your P&L and your equity balance, ensuring your financial statements accurately reflect that the options were never fully earned.

Step 3: Maintaining Compliance with the Right Systems

Managing IFRS 2 is not a one-off task. It is an ongoing process that requires tight alignment between your HR records of joiners and leavers, your legal documents for option grants, and your finance system. Neglecting this alignment creates significant risks during due diligence or an audit.

The Limits of Spreadsheets for Equity Management

For pre-seed and seed-stage companies, this is often managed in a spreadsheet. While functional at the start, this approach is highly prone to version control issues, broken formulas, and manual errors. These small mistakes can compound over time, leading to a significant and costly clean-up project when an investor or auditor requests a detailed breakdown of your equity and related expenses.

Migrating to a Cap Table Management Platform

Almost every venture-backed startup reaches the point where a spreadsheet is no longer sufficient. The reality for most startups at Series A is pragmatic: they migrate to a dedicated cap table management platform. Tools like Carta, Ledgy, and Capdesk are built for this purpose. They serve as the single source of truth for your equity. Most have modules that can automatically calculate the IFRS 2 fair value using the Black-Scholes model and generate the required expense schedule and journal entries. This dramatically reduces the risk of error and saves significant time.

Keeping this system aligned is critical for both financial reporting and tax compliance, particularly for EMI scheme accounting. A disqualifying event under EMI rules, if not tracked and accounted for properly, can lead to unexpected tax liabilities for your employees. Integrating your cap table software with your HR and finance systems ensures that when an employee leaves, the finance team is triggered to process the forfeiture correctly for IFRS 2 purposes, keeping your P&L and balance sheet accurate.

Key Actions for Compliant Share-Based Payment Reporting

Navigating IFRS 2 for the first time can seem daunting, but breaking it down into a clear process makes it manageable. The transition from a simple spreadsheet to a formal, auditable system is a positive sign of a maturing business preparing for its next stage of growth.

Here are the key actions to focus on:

1. Acknowledge the Requirement Early: Do not wait for an auditor to ask. If you are issuing EMI or other unapproved share options in the UK, you will need to comply with IFRS 2. Start the process as soon as you grant your first options to avoid a painful catch-up exercise later.
2. Use the Right Valuation Method: Remember, the IFRS 2 'Fair Value' is for financial reporting and is different from your HMRC valuation for tax. Auditors will insist on a separate, compliant IFRS 2 valuation, which is almost always higher. Using the Black-Scholes model with well-documented inputs is the standard approach.
3. Systemise the Accounting Process: Use the correct debit and credit journal entries to expense the option value over the vesting period. Set a recurring reminder to post the monthly journal in your accounting software to ensure it is done consistently and accurately.
4. Embrace the Right Tools for Scale: A spreadsheet will work at the very beginning. However, as your team and cap table grow, a platform like Carta, Ledgy, or Capdesk becomes essential for maintaining accuracy and efficiency in your share-based payment reporting.

Ultimately, understanding how to account for EMI options under IFRS 2 is about maintaining good financial hygiene. It provides an accurate picture of your true operational costs, ensures you are compliant with accounting standards, and builds the trust with investors that is essential for your next funding round. For more detailed information, see our Stock Option Accounting hub.

Frequently Asked Questions

Q: What is the difference between IFRS 2 and FRS 102 for share-based payments?
A: FRS 102 is the UK's domestic accounting standard, while IFRS 2 is the international standard. While broadly similar, FRS 102 can be simpler for smaller companies. However, most venture-backed UK startups adopt IFRS early on, as it is required for publicly listed companies and is what international investors expect to see.

Q: Do I need to apply IFRS 2 if my startup is very small and not yet audited?
A: Technically, if your accounts are required to present a 'true and fair view', then share-based payment expenses should be included. While you might delay implementation pre-audit, it is best practice to start early. Neglecting it creates a backlog of work that must be completed before your first audit or funding round.

Q: Can my company's accountant perform the Black-Scholes valuation?
A: While some accountants have the expertise, many do not specialise in this area. It often requires specific valuation software and experience in sourcing comparable company data for inputs like volatility. Using a specialist valuation provider or a cap table platform with a built-in valuation tool is often a more reliable option.

Q: How often do I need to run IFRS 2 calculations?
A: A full valuation using the Black-Scholes model is performed for each new batch of options on their grant date. The expense relating to those grants is then calculated and booked to your accounts monthly or quarterly. You do not need to re-value existing grants unless their terms are modified.