Time based vs Exit based - which is better?

When you set up your EMI Scheme one of the most important decisions you make is choosing whether your EMI Scheme is going to be a time based or exit based Scheme. (If you're a step ahead of this you can check out our article here on what exactly is an EMI scheme and why we think it's the best). This subtle difference in type of EMI Scheme has the potential to influence the direction of your start up and whether there is pot of gold waiting for your employees at the end of the rainbow (or in more cases after a certain tenure with a start up).

The two most common types of schemes under the EMI Scheme are time or exit based. With a time based EMI Scheme, options vest over a period of usually 2 to 5 years. Say for example you are given 5,000 options which vest every 6 months over 5 years. This means that every 6 months 500 options have vested and employees can exercise their options and convert these options into shares. Technically every six months employees are eligible to become a shareholder in the start up they are working for. After the five years (and assuming you still work at your start up and exercise your options) your employee is a shareholder who owns 5,000 shares.

An exit based EMI Scheme is virtually the same as a time based one but an exit event must occur for employees to be able to exercise their options. An exit event can be a sale of your start up, management buyout, listing or another change of control event. Employees of start-ups are typically not involved in the strategic decision making and direction of start ups, this is usually left to the investors and management. With an exit based EMI Scheme, options are only valid for 10 years. If at the end of 10 years no exit event has occurred, the options you gave your employees will lapse and are therefore worthless. (There are solutions to extend the time period but there are potential tax consequences and if after 10 years of hard work your employees haven’t received anything we don’t think extending the period will be motivating).

The big difference between the two types of EMI Schemes is certainty. With a time based scheme employees know that provided they continue to work for their start up and exercise their options they will become a shareholder. With an exit based scheme employees have limited control or influence over whether there is ever an exit event which creates uncertainty and ultimately does not help motivate or retain employees. Not all companies will ever have an exit event, many successful companies remain under the same ownership. By picking exit based EMI Scheme you are potentially robbing your employees of their options and the option for them to become a shareholder. This is not a super motivating experience for employees, and can leave them feeling like "what is the point?"

We dive into this here but it is so important to set up your EMI Scheme early to ensure all your employees are engaged, motivated and maximum their potential return. In the infancy of a start-up it is all a bit chaotic, you are trying to figure out basically everything and you don’t always get it right the first time.

Airbnb started trying to solve an accommodation shortage specifically for conferences and they even sold cereal at one point. Only after a few months did they realise that the real opportunity was in strangers letting strangers rent their properties no matter what the occasion. No founder fully knows the direction let alone the destination of where their start-up will be in five years time. Think about it for a second, did you know where you would be today five years ago? Similarly can you honestly tell yourself where you will be living, working or what you will be doing in your spare time five years from now? Chances are the answer is no. Therefore it is highly unlikely a start up founder knows where their start up will be five years from now.

By choosing an exit only EMI Scheme you have decided your destiny is an exit event often before you have even sorted out the fundamentals of your start up. If you never have an exit event your employees are not able to exercise their options and never become a shareholder. In these situations employees are left with an EMI Scheme which is worthless to them and not the pot of gold they were promised.

Based on our research we have found most founders opt for exit based EMI Schemes, however from our research we've realised how demotivating this is for employees, and it ultimately ends up backfiring for the founder too, which is why we at Pomelo think that time based should be a no brainer. Time based is the employee centric choice and therefore the most motivating for employees. Instead of focusing on an exit event and getting distracted by going through a sale process, we recommend you focus on building your start-up. If you do go through an exit event that is great and your employees will also benefit. However if that exit event never happens your employees will not be disadvantaged.

At Pomelo we are all about ensuring your employees are aligned, motivated and rewarded for their contribution.

After all they are one of your biggest assets and who doesn’t like to be rewarded? There are so many uncertain things in life. Reduce the uncertainty around employee options and equity but choosing a time based EMI Scheme. You can thank us later for retaining and motivating your employees by increasing the likelihood of that pot of gold at the end of the rainbow.