What’s an ESOP and why might I need one?
Last updated: 2021-06-24 (originally published on 2021-01-25) — by Will Elton
An Employee Share Option Plan (ESOP) is a scheme that sets out the framework under which share options go to its employees. It’s a common mechanism to incentivise employees.
What is an Employee Share Option Plan?
A share option plan is commonly used by companies to attract, reward, and retain talents. Typically their employees. Additionally, it is commonly known as an “ESOP” (Employee Share Option Plan). Essentially, it allows eligible employees to buy a certain number of shares at a price known as the exercise price. Then, these employees will benefit from the increase in value of the company by exercising their option to buy shares when the shares are at a price greater than the exercise price.
What is a share option?
Importantly, a share option is not a share. Instead, it is a right to acquire shares when it is exercised. Share options are usually “vested” over time or upon fulfilling certain conditions (e.g. performance targets). Basically, this means that the option holder becomes able to exercise the right and acquire shares in the company.
What is share vesting?
Chiefly, share vesting is a mechanism by which an employee’s options tie into a schedule and/or conditions. A vesting period is the length of time that an employee must wait in order to be able to exercise their options.
It is customary for the first vesting period to include a “cliff”. This means the share options will be exercisable by the employee only at the end of this initial period.
A common vesting schedule can stipulate that 20% of the options will vest equally over the next 5 years. Performance targets can also tie into the vesting of the options.
What is the difference between an Employee Share Option Plan and a Share Vesting Agreement?
A Share Vesting Agreement is a mechanism for employees to purchase shares which are subject to a vesting period. An Employee Share Option Plan is a mechanism for employees to get share options which are also subject to a vesting period. But which they can exercise at a later date.
More information on the differences between the two mechanisms can be found in this article: How do I reward my team with shares or equity?
What is the process to establish an Employee Share Option Plan?
1. Drafting an Employee Share Option Plan
2. Adopting the Employee Share Option Plan
3. Granting Options to Employees
Step 1) How to draft an Employee Share Option Plan
The Employee Share Option Plan establishes the general rules under which the board will grant the options.
An ESOP typically sets out the purpose of the plan (e.g. to incentivise employees). Also, who will be eligible to participate in the plan (e.g. employees of all levels or a certain level or above). And, most importantly, the overall size of the pool of shares that the option holders will be able to buy.
The Employee Share Option Plan also generally sets out how to grant an option. And, how to exercise an option granted. As well as what happens when the option holder leaves the company or dies.
Step 2) How to adopt an Employee Share Option plan
The Employee Share Option Plan must be formally adopted by a Shareholders’ Resolution to Adopt Share Option Plan or a Directors’ Resolution to Adopt Share Option Plan.
Essentially, the Employee Share Option Plan should specify the maximum number of shares they can issue under that plan. The company can change this number later by amending the stock plan with approval of the board and stockholders. The company must reserve the shares for allocation under the plan. And it must have enough shares available for issuance in order to do so. The reserved shares are often collectively referred to as an option pool or stock option pool.
Step 3) How to grant employee share options?
Basically, following the adoption of the Share Option Plan, the company may now grant options to individuals by issuing Option Certificates. The company must legally to issue an “Option Certificate”, which sets out the terms and conditions of the ESOP.
Additionally, it is also customary for the company to issue a Letter for Grant of Option as a cover letter. This provides more details regarding the procedures to follow for the exercise of the option by the employee.
What are tax-advantaged employee share option plans? (UK specific)
Schemes that get approval by HM Revenue and Customs (HMRC) offer tax benefits to both employers and employees. Participants do not pay income tax or national insurance contributions on the purchase of shares at less than their market value, the receipt of free shares, the grant of an option to buy shares, or the exercise of an option to buy shares.
What is an Enterprise Management Incentive (EMI) scheme? (UK specific)
An Enterprise Management Incentive (EMI) is there to help small, higher-risk companies recruit and retain employees. They are usually put in use to benefit key employees or key groups of employees. Each option entitles the employee to acquire shares in the company in the future. This will be at a price agreed at the date of the grant. If the value of the shares rises between the option and exercise dates, the employee benefits.
An Employee Share Option Plan (ESOP) usually falls under an Enterprise Management Incentive (EMI) scheme.
There are three other similar kinds of eligible schemes:
Share Incentive Plans (SIPs): all-employee schemes in which every member of the workforce, including part-timers, is entitled to participate. Participants are awarded shares directly rather than granted options that entitle them to acquire shares in the future.
Savings Related Share Option Schemes (SAYE or Save as You Earn schemes): another all-employee scheme in which employees get options to exercise after three, five, or seven years. The option amount is taken each month after which the employees are given the option to buy the shares or recuperate the capital investment. Usually larger, often listed, companies favour this option.
Company Share Option Plans (CSOPs): similarly to the Enterprise Management Incentive scheme, a CSOP grants options to acquire shares to participating employees. Whilst the tax advantage is less attractive than an EMI, companies unable to qualify for an EMI may opt for a CSOP.
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