ESOP 101: Understanding Vesting, Exercise, and Expiration Terms Part-2
By Joanne Hue, Updated: 2023-08-16 (published on 2023-03-30)
An Employee Stock Ownership Plan or ESOP is a benefit plan that provides employees of a company the option to purchase stocks in a company at a fixed exercise price. For the sponsoring company, the shareholders, and the participants, ESOP provides various tax-related benefits, making ESOP a qualified plan.
Companies set ESOP schemes to overlap the interests of the workers with that of the shareholders. Employers often use ESOP as a strategy for corporate finance by aligning the interests of the employee with that of the shareholders and the company. You can understand ESOP is a share option plan, used by companies to incentivize, sustain and reward competent employees.
The terms of an ESOP sets a vesting period after which the employee who owns the option can exercise their rights. This option should be exercised before its termination.
How is ESOP Vested?
When employees participate in a share option under the company they work for, the Employee Stock Option Plan often requires time before it is officially vested in the employee. This period is known as the vesting period.
The period between the issuance of the share option and the point at which a participant can exercise them is known as the vesting period. Only after the completion of the vesting period, the participant gets to enjoy their rights in relation to the option. Until its expiration, the participants cannot access the benefits of their rights.
There may be circumstances when the participant leaves the workplace prior to the expiration of their vesting period. When the employee resigns or stops working for the company for some other reason, the unvested option is no longer available to them.
The length of the vesting period will depend on the rules of the scheme. Since there is no standard vesting period, the time is determined by the company. Usually, it tends to be between 12 months or 3 years- depending on company policies and the structure of the plan. Setting a vesting period is observed in practice, however, it is not mandatory for a stock scheme.
An ESOP has a rule of the scheme, that determines the length of the vesting period. Since the primary purpose of an option scheme is to ensure that an employee’s action aligns with the interest of the shareholders and the company, most option schemes tend to have a standard vesting period. For option schemes, however, vesting periods are almost standard. The vesting period is required to avoid participants getting disincentivized to their employment duties. If the options were to be vested immediately, companies may not be able to observe long-term loyalty from their employees.
What is ESOP Excercise Price?
The exercise price in an ESOP is the price at which a stock option holder has the right to purchase the stock. An option holder is not obligated to purchase shares in the company, it is simply a right that they hold. The exercise price has a determined term within which employees with vested rights can purchase stocks in the company. The company has the liberty to set the exercise price contingent on the fact that they adhere to accounting policies and regulations.
The employer and employee participating in the option scheme agree on the ESOP terms on the grant date. An ESOP is only vested when the employee has fulfilled their requirements within the vesting period. After the vesting, the employees have the right to exercise their rights. The right to exercise their option has limitations and should be exercised within the agreed term. They may choose to purchase their options within the time frame.
The stock options that the employees hold are generally issued at an exercise rate that is lower than the fair market value. The fixed exercise price is distinct from the fair market value as the former lacks the equity option. When the stock prices observe a rise, the employees profit by exercising their options at the strike price.
What are the Expiration Terms used in ESOP?
The expiration term for an ESOP is the last date at which an employee may exercise their option. An un-exercised option expires defacto after the expiration term. While the expiration date is distinct for each ESOP plan, generally, the option expires after ten years from the date of vesting. Sometimes, the option expires when the employee leaves the company. Any additional unvested options are forfeited after the end of the employment.
For ISO companies, the employees have 90 days after the vesting of the option to exercise their rights. For NSOs, the term is dedicated by the company. For ISOs, you will have 90 days to exercise any options you have vested. For RSUs or Restricted Stock Units, converting options into company shares is possible but it has tax implications. Public company stocks tend to be cashed out by employees when they leave.
Employees who hold stock options that are approaching the expiration term tend to face dilemmas on whether or not to purchase stocks. Such employees must consider whether they trust the company to have a successful future. If the answer is yes, and they can afford to purchase the stock consideration to all the risks associated with the purchase, they should go forward with it.
If you are an employee who does not believe that owning stocks in the company you are currently employed in will be beneficial to you, then you need to exercise the option just because you have it. You should only purchase the stocks if your company is following a trend or amassing profit.
An Employee Stock Option Plan provides the employees of the company an opportunity to hold shares in the company they work for. This can be extremely beneficial to the employees due to the tax benefits associated with the plan and the availability of stocks at a price lower than the fixed market value. In order to incentivize employees to perform their duties diligently and in favor of the shareholder’s interest, ESOP schemes set a vesting period. After the termination of the vesting period and the fulfillment of agreed requirements, employees are vested with the right to exercise their share options. They may choose to purchase shares in the company prior to the expiration of the term. If an employee leaves the company, prior to the expiration term, they hold the chance of losing their option.
You may also like:
- ESOP 101: Introduction to Employee Share Option Plans (Part 1 of 10)
- What’s an ESOP and why might I need one?
- Employee Share Option Plan Template
- ESOP – Employee Acceptance Letter Template
- How to Set up your company option scheme?