ESOP 101: Risk and Compliance with Stock Option Scheme Part 8
By Joanne Hue, published: 2023-04-13
An Employee Stock Option Plan or ESOP is a method of allowing employees to gain ownership in the company. An ESOP is set with the intention of aligning the interests of the shareholders and the employees. It provides tax benefits to the participants of the program.
While ESOP can be attractive to businesses, there are risks associated with it. If the participants fail to understand the complexity and the fluctuations associated with shares traded through ESOP, the scheme can be detrimental to the company and its employees.
Risks associated with Stock Options
Stock Option Plans for employees are an excellent method of increasing a company’s productivity. However, an ESOP setting is not immune to risks. If you are an employer or an employee thinking about participating in an option plan, you will need to be aware of the following risks associated with ESOP:
1. Rules of an ESOP can be complicated
With improper oversight, implementing the rules and regulations concerning ESOP might be a problem. The operating rules of ESOP are said to be complicated and companies are often required to hire third-party operators and advisors to run a stock option scheme. Third-party administration may fail to keep the company’s best interest in mind while running the scheme. It is therefore crucial to have an internal agent in the administrative team. If the provisions concerning the requirements of ESOPs are not fulfilled it may lead to a violation of laws. This may particularly impact smaller companies and companies that do not have efficient accounting structures. Businesses that lack the required infrastructure to set an ESOP are at risk of violating ESOP protocols. Therefore, if your company lacks the required resources and information for an ESOP setting, a stock option plan may not be the best idea for you.
2. It is subject to fluctuations
If your company has an unstable and unpredictable pattern of revenue, chances are your employees will not benefit from the ESOP. This will in return impact their performance, creating counterproductive results. ESOPs are more suitable for companies that do not exhibit large fluctuations in their value. This way, the stock option holder can make reliable predictions to exercise their vested rights. Companies that exhibit volatile patterns are not best suited for stock option plans. Such companies are also more likely to lay off employees to economize. Providing equity to option to their employees is not in the best interest of these businesses. Larger companies with stable revenue are not completely immune to the risks of value fluctuation. An ESOP could be ineffective in times of economic uncertainty like inflation.
3. It may create a succession problem
Shares to set an ESOP structure are often contributed by shareholders seeking retirement options. As there is no third party-buyer and the share transaction occurs internally, ESOP can impact internal liquidity transactions. Likewise, a majority shareholder seeking retirement could mean that they are not active in the role of establishing a successor to their leave. This could create a crisis of succession within the company. An owner who wishes to retire will need a qualified successor to oversee operations within the company and manage transaction debts. In the absence of a successor contributing shares for an ESOP is an unfitting strategy.
4. ESOPs may risk company finance
If your company is in dire need of financing, it is wiser to involve a third-party investor. ESOP is a long-term solution for company operation and cannot tend to the immediate financial needs of the company. The period of vesting and the decision of the employee to purchase shares covers a long span of time and tends to be unpredictable. A company cannot rely on its employees for its financial requirements. ESOPs provide employees with a share option plan at a fixed price. This means that employees can benefit from the option plan when the prices of the company stocks increase. However, this is a terrible strategy for companies seeking to expand financially. An ESOP is not suitable for companies in need of additional capital for endurance. If If the company requires additional capital to endure, it should avoid an ESOP.
5. ESOP may be incompatible with shareholders
Shareholders wishings to maximize cash and generally seek third-party buyers like a private company. In this case share transactions through ESOP may not be in the best interest of the shareholders. Shareholders may be able to find buyers who are willing to pay the premium fair market value. While ESOP could help increase the company’s productivity by aligning the interests of the employees with the shareholders, a company may find better options for transactions for financial motives.
Corporate Governance Considerations with Stock Option Scheme
Companies create ESOP committees for the administration of employee option schemes. These committees are also called administrative committees or ESOP planning committees. These committees are not statutorily defined and are created for the purpose of structuring the stock option plan. Therefore, they are created in the plan document.
The ESOP committee is responsible for estimating the suitable scale of the stock option plan to be introduced in the company. They design the plan and provide recommendations to the board of directors of the company. In some cases, the committee may overlook fiduciary issues like reducing the benefits for the participants. Other fiduciary decisions made by this committee entail directing the trustee of the plans in decision-making, The committee may also simply hold an advisory role in the company. They may be responsible for communicating the details of the scheme to the participants, allocating the participants, and determining the option pool. The committee is comprised of individuals holding expertise in the legal, and fiduciary matters concerning the ESOP. It may or may not include an internal agent.
The company can choose to limit the role of the committee. There have been instances where the board of directors for the company act as the ESOP committee. Since the board of directors is elected by the shareholders in the annual general meetings, the involvement of the board in the ESOP means that shareholders’ concerns with the ESOP are better dealt with.
Irrespective of the formation method of the ESOP committee, their prime role is to determine matters such as qualification metrics to be set for the employees who can partake in the ESOP, the term for vesting, the price rate of shares, allocation of shares, suitability of the stock scheme with company finances, and security of tax benefits for the participants. Corporate government plays a key role in structuring an ESOP within a company as a stock option scheme requires approval from the board of directors prior to being set.
Fluctuation in company value, succession related-issues, financial necessities, and shareholders incompatibility may risk the success of an Employee Option Scheme. Particularly, small-scale startups and companies with inefficient accounting systems should avoid setting an ESOP without analyzing the risks it may pose. In order to set an option scheme, companies require an ESOP committee that is approved by the board of directors. This committee designs the plan for the stock options and is responsible for communicating with the participants.
You may also like:
- ESOP 101: Introduction to Employee Share Option Plans (Part 1 of 10)
- ESOP 101: Understanding Vesting, Exercise, and Expiration Terms Part-2
- ESOP 101: The Process to Set Up an Employee Share Option Scheme Part 3
- ESOP 101: Communicating and Administering an ESOP – Part 4
- ESOP 101: Tax Implications and Accounting of an ESOP Part 5
- ESOP Benefits for Employees, Business, and Shareholders (Part 6 of 10)
- ESOP 101: Option Scheme Drawback and Maximizing Value Part 7