A seed term sheet often includes a line such as founder vesting: four years, one-year cliff, standard reverse vesting. It means that if a founder leaves in year two, the company can buy back the shares they have not yet earned.

Vesting also changes how the shares are taxed, and it starts a 14-day deadline for a one-page election. If the election is missed and the shares were worth more than the founder paid, part of the proceeds of a later sale can be taxed as employment income at up to 45%, with National Insurance, where it would otherwise be a capital gain taxed at 18%.

How reverse vesting differs from options

Under reverse vesting you already own the shares. They are issued to you on day one, they carry votes and dividend rights, and they count as yours for capital gains tax from that day. What the company gets in exchange is a contractual right to buy some of them back, usually at the price you paid, if you leave before the vesting schedule completes.

With options, you own no shares until you exercise them. Investors ask founders for reverse vesting because the founders keep their shares, so the two-year qualifying period for Business Asset Disposal Relief keeps running and any existing SEIS or EIS relief is not disturbed. The company's right to buy the shares back brings them within the tax rules below.

How a buy-back right makes shares restricted securities

Shares acquired by reason of an employment or an office are employment-related securities under Part 7 of the Income Tax (Earnings and Pensions) Act 2003. Founder shares almost always are, because the founders are directors and HMRC treats their shares as connected with that role.

A right for the company to reacquire the shares for less than they are worth if the holder stops working there is a forfeiture condition, and shares carrying one are restricted securities under section 423. From then on the shares have two values:

  • Unrestricted market value — what the shares would fetch if the buy-back right did not exist.
  • Actual market value — the lower figure a buyer would pay knowing it does.

The tax that follows depends on the unrestricted market value on the day the shares were issued and on what was paid for them.

No tax when the shares are issued

Section 425(2) says that where a forfeiture condition will end within five years of acquisition, there is no income tax charge when the shares are acquired. Four-year vesting ends within five years, so there is no tax to pay or report when the shares are issued.

The charge is postponed. Section 427 sets out three chargeable events. The first is the restrictions ending, for example when vesting finishes. The second is a restriction being varied. The third is the shares being sold to an unconnected person while still restricted. The charge therefore usually arises when vesting ends or when the company is sold, whichever comes first.

What gets charged is a proportion of the value at that moment. The proportion is fixed on day one: take the unrestricted market value when the shares were issued, subtract what you actually paid for them and anything already taxed as income, and divide by that unrestricted value. Pay the full unrestricted value and the proportion is nil, permanently. Pay £20 for shares worth £240,000 and the proportion is 99.99%, so 99.99% of the value at the chargeable event is taxed as employment income.

The section 431 election and its 14-day deadline

Section 431(1) lets the employer and the employee jointly elect to treat the shares as though they had never been restricted. The employee accepts an income tax charge at acquisition on the unrestricted market value less what they paid, and any growth in value after that date is then taxed as a capital gain.

The election must be made no later than 14 days after the date the shares are acquired. The deadline cannot be extended, and there is no procedure for a late election and no reasonable excuse provision. It must be signed by both the company and the individual. It is kept with the company's statutory records and is not sent to HMRC, so it needs to be stored where it can be found later.

Worked example: a co-founder given shares at the seed round

The figures below are illustrative. A company incorporated fourteen months ago has two founders holding 800,000 ordinary shares each, subscribed for at £0.0001 a share when the business had no value. They paid the full unrestricted market value, so none of their future gain can be taxed as employment income under these rules.

The seed investor wants the chief technology officer, who joined in month nine, to hold shares. She is issued 200,000 ordinary shares at £0.0001 each, £20 in total, with four-year reverse vesting and a one-year cliff, meaning none of her shares vest in the first year. The round closes at a valuation of £2,400,000 after the investment, across 2,000,000 shares, so each share is worth £1.20 and her shares have an unrestricted market value of £240,000 on the day they are issued. Her salary is £30,000. Four years later the company is sold at £6.00 a share and her 200,000 shares sell for £1,200,000.

Path A: no election signed
No charge on acquisition, because the forfeiture ends within five years. Uncharged proportion: (£240,000 − £20) ÷ £240,000 = 99.99%.
The sale is a chargeable event, so £1,199,900 is taxed as employment income.
Income tax, on top of her salary: £536,172
Employee National Insurance, at 8% up to the upper earnings limit and 2% above it: £24,099
Employer National Insurance at 15%: £179,985
Capital gains tax: nil, because the amount taxed as income is added to her base cost, making it £1,199,920
Path B: section 431 election signed within 14 days
Income tax now on £240,000 − £20 = £239,980, added to a £30,000 salary: £104,208, payable by 31 January after the end of that tax year.
On the sale: gain of £960,000, less the £3,000 annual exempt amount, at the 18% Business Asset Disposal Relief rate: £172,260
Total: £276,468
The same £1,200,000 sale taxed two ways: £740,256 of tax with no section 431 election against £276,468 with one Tax on a £1,200,000 sale, with and without the election £1,200,000 of proceeds. Illustrative figures, 2026/27 rates. No election Tax £740,256 Kept £459,744 Section 431 election £276,468 Kept £923,532 Difference: £463,788, including employer’s National Insurance, which is often passed to the seller. Path B pays £104,208 four years earlier, on shares that cannot yet be sold.

Leaving out employer's National Insurance, the difference in her own tax is £283,803. If the employer's National Insurance is passed to her through a joint election, as sale agreements often require, the difference is £463,788.

The cost of the election at incorporation and after a funding round

Path B means paying £104,208 of income tax by 31 January after the end of the tax year, on shares that cannot be sold and may end up worthless. A co-founder who does not have that cash may not be able to make the election.

At incorporation the same election costs almost nothing. Shares subscribed for at nominal value on the day the company is formed, before there is a product, revenue or a term sheet, have an unrestricted market value equal to what was paid, so the tax charge on the election is at most a few pence. Sign the election anyway, because it protects against HMRC taking a different view of what the shares were worth, which is more likely if founders subscribe after intellectual property has been transferred to the company, after the first customer has signed, or once a term sheet has arrived.

As the business grows, its shares are worth more, so ordinary shares issued at nominal value carry a larger income tax charge on the election, or a larger exposure without one.

What to give someone who joins after the company has value

Once the company has a value, issuing ordinary shares at nominal value leaves a choice between a large tax bill now and a larger one on a sale. Two structures avoid this:

  • EMI options. No income tax on grant, and none on exercise where the option was granted at not less than the actual market value agreed with HMRC. Business Asset Disposal Relief is available on the resulting shares without the usual 5% personal company test, and the two-year qualifying period runs from the date the option was granted. Our post on the 2026 EMI limits and qualifying conditions covers who can use it.
  • Growth shares. A separate class that only participates in value above a hurdle set at the current valuation. Because the class is worth very little on the day it is issued, it can be subscribed for at close to its unrestricted market value. That leaves little or nothing to be taxed as employment income later, and makes a section 431 election cheap.

Both need a valuation that can be supported, agreed before the shares or options are issued.

The annual Employment Related Securities return

Issuing employment-related securities creates an annual reporting duty. The arrangement has to be registered on HMRC's Employment Related Securities online service, and an annual return filed by 6 July following the end of the tax year, including nil returns once a scheme is registered.

The penalties are automatic and they escalate: £100 on 7 July, a further £300 if the return is still outstanding three months later, another £300 at six months, and HMRC may charge £10 a day after nine months. Paying a penalty does not remove the duty to file, and further penalties can follow until the return is filed.

What to do this week

  1. List every share issue the company has ever made and put the date, the price paid and the number of shares against each one.
  2. For each issue, find out whether a section 431 election was signed, and find the signed copy.
  3. Flag any issue made in the last 14 days, because an election can still be made for those shares.
  4. For every issue where no election exists, work out what the shares were worth on the day and what was paid. The difference between those two figures, as a percentage of what the shares were worth, is the share of a future sale that could be taxed as employment income.
  5. Check whether the company is registered on the Employment Related Securities service and whether the 6 July returns have been filed for every year since the first share issue.
  6. Before the next round closes, agree with your lawyers that any section 431 elections are drafted, signed and dated on the same day as the share issue.
  7. If anyone is about to be given ordinary shares at nominal value in a company that now has a valuation, work out the cost of EMI options or growth shares first.

Our guide to paying yourself as a founder covers salary and dividends. If you are raising money from investors, our comparison of an advance subscription agreement against a convertible note covers which document to use. If your company has SEIS or EIS investors, read our post on SEIS and EIS as well, because changes to the share structure can affect their relief.

Where we help

We work out the unrestricted market value on each share issue, get section 431 elections signed within the 14 days, register the scheme and file the annual returns, and compare EMI options and growth shares before anyone signs a stock transfer form. Where elections were missed in the past, we work out the tax exposure so the figure is known before due diligence starts. We also handle founder share splits and vesting, and keep the register of members in line with each issue. A founder share restructure is £750 + VAT and each later share issue is £195 + VAT, as set out on our share structure and cap tables page, and your monthly accounting fee comes from the instant quote. Get started.