As an SME or startup owner, you are probably familiar with selling shares to acquire capital.
However, if your business doesn't have a record of providing solid ROI but is tipped to proliferate, trading in or offering stock options is a way of attracting the necessary investment and skilled talent you need to meet growth targets.
In this article, we explain everything you need to know about stock options.
What is options trading in the UK?
Options trading is the act of buying and selling options. It occurs when an individual buys a contract that gives them the right to purchase an underlying asset at a pre-determined price on a specific date.
Assets that can be traded as an option include:
- Forex currency
- Commodities, for example, oil or gold (although futures rather than commodities is more common for this class)
- Stocks (shares)
What is a stock option?
A stock option involves someone purchasing a contract from your company that allows them to buy shares at a pre-determined price on a specific date.
The three key elements of a stock option contract are the following:
- Premium paid – the cost of the options contract itself
- Strike price – the price at which the holder will purchase the shares in your company if they decide to exercise their option
- Expiration date – the date by which the option must be exercised before it expires
What are the different types of options?
There are two main types of options:
- Call option – gives the holder the right but not an obligation to buy the asset at the strike price on or before a set date. If the stock decreases its value, the maximum potential loss is the premium paid to purchase the call options. Call options should be bought during a rally (a period of increases in the prices of stocks), and they should be sold when no longer expected. When selling a call option, you're selling the right to purchase an underlying security at a set price before a certain date.
- Put option – gives the holder the right, but not the obligation, to sell the asset at the strike price on or before a set date. Traders usually buy a put option to magnify a stock's declined profit.
How do stock options work?
Imagine an investor has £1,000 to invest and decides to purchase your company’s stock, currently trading at a stock price of £20 but expected to increase in value. They could invest £1,000 to purchase 50 shares. If your company’s stock rises to £25, the investor makes a profit of £5 per share for £250 or a 25% ROI.
Now, if an investor buys call options on stock with a strike price of £20 with the shares currently selling at £2 each and expected to increase, they can buy 500 options which would allow them to purchase 500 shares in your company on or before the expiration date.
Suppose the value of the stock rises to £25. In that case, the investor can exercise their option to buy 500 shares and immediately sell them for a profit of £2,500, which, allowing for the subtraction of the original capital invested (£1,000), equals an ROI of 150%.
What are the benefits of trading in stock options?
If your company is performing well, the strike price of your stock will be lower than its fair market value by the time your options vest, so you can buy your company stocks for a lower price and sell them at the higher fair market value.
Benefits to company owners include:
Stock options increase an investor’s chance of making a significant ROI compared to simply buying your company shares (as seen above).
For small businesses with positive growth predictions but little turnover/profit track records, especially in the STEM sector, trading in stock options is an ideal way to access the capital needed to grow.
- Small startups can use share option schemes to attract and retain talented employees.
What happens when stock options expire?
There are different situations occurring at expiration depending on whether the option is in-the-money (ITM) or out-of-the-money (OTM).
If an option has intrinsic value to the owner, it is considered ITM, and if it does not, it is considered OTM.
If an option expires in the money, it will be automatically converted into 100 long or short shares of stock in the associated underlying.
Market participants may decide not to exercise a given option for long in-the-money options.
As a relief, options do not expire worthless as frequently as many believe. Most positions are closed before expiration.
Will selling/offering stock options provide any tax advantages for my company?
If you set up a company share option plan (CSOP) or create an enterprise management incentives (EMIs) you may pay less corporation tax when the options are exercised.
Trading in or offering stock options provides a way for SMEs and startups to access investment, providing the capital they need to grow.
How are stock options taxed?
You should consider how stock options are taxed in the UK to ensure you comply with the laws associated with stock options and your organisation’s HMRC obligations.
When you buy an open-market option, you're not responsible for reporting any information on your tax return.
However, when you sell an option—or the stock you acquired by exercising the option—you must report the profit or loss in your tax return form.
Tax treatment of options can be complex; investing in specialist legal advice is vital.
Get legal assistance from LawBite
Our solicitors can guide you through the regulatory and tax framework surrounding selling stock options or how to buy stock options and answer all your questions, allowing you to set up your scheme/s confidently and successfully.
LawBite has experience helping startups and businesses achieve their long-term commercial ambitions and regulatory compliance.