Unapproved Share Options in the UK: Complete Guide for Founders to Tax, Valuation, Compliance

Unapproved Share Options in the UK: A Complete Guide for Founders

For many UK startups scaling past the early stages, the limitations of tax-advantaged schemes become a practical barrier. Enterprise Management Incentive (EMI) schemes are unavailable for companies with over 250 employees, certain corporate structures, or those in restricted industries. This is where knowing how to set up an unapproved share option scheme in the UK becomes an essential tool for growth. It provides the flexibility to grant equity to a wider range of participants, including vital international talent, without restrictive caps. This guide provides a clear path through the valuation, tax, and reporting requirements, designed for founders managing finance with tools like Xero and spreadsheets.

What Are Unapproved Share Options?

First, let's clarify the terminology. An 'Unapproved' Share Option scheme is any scheme that does not meet the specific criteria for HMRC's tax-advantaged plans like the EMI scheme. The name can be misleading; it simply means the scheme does not qualify for preferential tax treatment, not that it is illegitimate. The reality for most pre-seed to Series B startups is more pragmatic: unapproved options are often the only viable way to offer equity to everyone who contributes to growth.

The Primary Benefit: Unmatched Flexibility

If they aren’t ‘tax-advantaged’, what’s the point? The primary benefit is flexibility. Unlike EMI schemes, unapproved schemes have no statutory limits on the value of options an individual can hold or the size and type of the company. This freedom allows you to grant options to a much broader group of contributors, which is crucial for modern, globally distributed teams.

• International Employees: Grant options to team members outside the UK, which is impossible under EMI rules.
• Advisors and Consultants: Reward non-employees like advisors and contractors who provide critical expertise.
• No Company Size Limits: Use the scheme even if your company grows beyond the 250-employee limit for EMI.
• No Individual Value Caps: Grant options worth more than the £250,000 individual limit imposed by EMI schemes.

The Fundamental Trade-Off: Tax Treatment

The flexibility of unapproved options comes with a clear trade-off in its tax treatment. Instead of the employee’s gain being treated mostly as a capital gain upon sale of the shares, the key taxable event is shifted earlier. The main taxable event for the employee is at Exercise, where the gain is subject to Income Tax and National Insurance Contributions. This is the core difference founders and employees must understand.

Common Misconception
Myth: 'Unapproved' means the scheme is illegitimate or frowned upon by HMRC.
Reality: It's an administrative label, not a judgement. It simply designates any scheme that falls outside the strict rules for tax-advantaged plans. They are a standard and fully compliant part of UK equity compensation.

The Employee Experience: How It Works for Your Team

For an employee, understanding the journey from receiving options to a potential cash payout is crucial. It is your job as a founder to explain this clearly to manage expectations and avoid financial surprises. The process unfolds over four key events.

1. Grant: The company grants the employee the right (the option) to buy a specific number of shares at a fixed price in the future. Typically, no tax is due at this stage, provided the exercise price is not less than the shares' actual market value at the time of the grant.
2. Vesting: The employee meets conditions over time, such as continued employment, to earn the right to exercise their options. The vesting period is a contractual milestone, not a taxable event.
3. Exercise: The employee pays the agreed exercise price to convert their options into actual shares. This is the main taxable event. The difference between the market value of the shares at exercise and the exercise price is treated as employment income, subject to Income Tax and National Insurance.
4. Sale: The employee sells their shares, ideally for a profit during an exit or secondary sale. Any growth in the shares' value between the date of exercise and the date of sale is subject to Capital Gains Tax.

Numerical Example: Employee Tax Calculation

Consider a software engineer at a SaaS startup who was granted 5,000 options.

• Exercise Price (at Grant): £0.50 per share
• Market Value (at Exercise): £8.00 per share

When she exercises all 5,000 options, her gain for tax purposes is calculated as follows:

• Market Value at Exercise: 5,000 shares x £8.00 = £40,000
• Cost to Exercise: 5,000 shares x £0.50 = £2,500
• Taxable Gain (Employment Income): £40,000 - £2,500 = £37,500

This £37,500 is subject to her marginal rate of Income Tax and Employee's National Insurance Contributions, which the company may be required to withhold via payroll.

Getting the Financials Right: Valuation and Tax Impact

Accurately valuing your shares and forecasting the company's tax liabilities are two of the most significant challenges when setting up an unapproved share option scheme UK founders face. Getting this wrong can create unexpected tax bills for employees and cash flow problems for the business.

Valuation: Your First Line of Defence

Setting the exercise price requires establishing the Actual Market Value (AMV) of your shares at the grant date. While a formal HMRC valuation is not mandatory as it is for EMI, a well-reasoned, defensible valuation is crucial. It supports the exercise price and minimises the risk of HMRC challenging it later, which could trigger an unexpected tax charge for the employee. For added certainty, companies can use HMRC's post-transaction valuation check service, Form VAL231. This step is highly recommended as it prevents significant headaches down the line.

Company Tax Costs and Benefits

When an employee exercises their options, it creates a direct cost for your company. The business must pay Employer's National Insurance Contributions (NICs), currently 13.8%, on the employee's taxable gain at exercise. This is a real cash cost to your business that must be paid to HMRC.

Using our software engineer's £37,500 gain, your company’s liability would be:

• Employer's NICs: £37,500 x 13.8% = £5,175

If multiple employees exercise at once, for example during a funding round or acquisition, this can create a substantial drain on cash. This must be factored into your financial model.

However, there is a valuable tax benefit. The sum of the employee's gain and the employer's NICs is typically deductible against the company's profits for Corporation Tax purposes. In our example:

• Total Deductible Amount: £37,500 (employee gain) + £5,175 (employer NICs) = £42,675

This £42,675 can be offset against your taxable profits. This distinction is crucial for cash flow planning; the Corporation Tax relief is realised later, but the Employer's NICs payment is an immediate liability.

Staying Compliant: Administration and Reporting

While more flexible in structure, unapproved option schemes come with strict administrative duties. Failing to meet these HMRC share option rules can lead to investigations and financial penalties. Staying on top of these deadlines is essential.

Registration and Annual Reporting

The first step is registration. The scheme must be registered with HMRC's Employment-Related Securities (ERS) service online. This must be done by 6th July following the end of the tax year in which the first grant occurs. For example, if you grant your first options on 1st October 2024 (in the 2024/25 tax year), you must register the scheme by 6th July 2025.

Once registered, compliance becomes an annual task. An ERS return must be filed online every year by the 6th July deadline. This is required even if it is a 'nil return' where no options were granted or exercised in the tax year. Missing this deadline results in automatic penalties, so setting an annual calendar reminder is a simple but effective control.

Withholding Obligations (PAYE)

Your responsibilities may extend to collecting tax on your employees' behalf. If the shares they acquire are 'readily convertible assets' (RCAs), the company must operate PAYE withholding for Income Tax and NICs on the gain at exercise. A share is considered an RCA if a ready market exists, such as on a stock exchange, or if a trading arrangement is in place, like a planned acquisition.

For most private startups, shares are not RCAs at grant. However, if options are exercised immediately before a sale of the company, the shares become RCAs. At that point, the company is required to operate PAYE through its payroll. This means calculating the tax and NICs due and remitting it to HMRC, a process that requires careful coordination between your legal and finance functions.

Practical Takeaways for Founders

Implementing an unapproved share option scheme provides immense flexibility, but it requires diligent management. For founders navigating this without a dedicated finance team, focusing on a few key principles is the path to success.

• Embrace Flexibility: Use unapproved options strategically to attract the best talent, wherever they are based, and to reward advisors who fall outside the strict confines of EMI schemes.
• Plan for Cash Flow: The Employer's NICs liability at exercise is a significant cost. Model this liability in your financial forecasts to ensure you have cash available, especially around funding rounds or an exit.
• Make Compliance a Routine: The 6th July ERS filing deadline is absolute. Set calendar alerts and treat it with the same importance as your VAT or Corporation Tax returns to avoid penalties.
• Invest in Valuation: A defensible valuation provides certainty for you and your team, ensuring your equity plan is a powerful incentive, not a source of future tax problems. See our guide on option pool sizing to get started.

Frequently Asked Questions

Q: Can we grant unapproved options to contractors or international employees?
A: Yes. This is a primary advantage of non-EMI share schemes. Unapproved options provide the flexibility to grant equity to UK-based non-employees like advisors and to any team members located internationally, which is not possible under the strict EMI rules.

Q: What happens if HMRC decides our valuation at grant was too low?
A: If HMRC successfully challenges your valuation and deems it was lower than the Actual Market Value (AMV), the difference can be treated as taxable income for the employee at the time of grant. This is why a well-documented, defensible valuation is critical to avoid creating an unexpected tax liability for your team.

Q: Do we have to file an ERS return every year if there is no activity?
A: Yes. Once a scheme is registered with HMRC, you must file an annual ERS return by 6th July each year. Even if no options were granted, exercised, or cancelled, a 'nil return' must be submitted to remain compliant and avoid automatic late-filing penalties.

Q: Do we need a lawyer to set up an unapproved share option scheme?
A: While not legally mandatory, it is highly advisable. An experienced solicitor ensures your scheme rules and option agreements are robust, compliant with UK company law, and protect both the company and participants. Getting professional advice minimises legal and tax risks down the line.