ESOP 101: Introduction to Employee Share Option Plans (Part 1 of 10)
By Joanne Hue, published: 2023-03-28
What is an ESOP?
An Employee Stock Option Plan or ESOP is a benefit plan that provides employees of a company the ownership interest in the form of stocks or shares. For the sponsoring company, the shareholders, and the participants, ESOP provides various benefits in tax. This makes ESOP a qualified plan.
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. In other words, ESOP is a share option plan, used by companies to incentivize, sustain and reward competent employees. Through this share plan, eligible employees can purchase a certain number of shares in the company at an exercise price. Therefore, employees benefit when the share prices for the respective company increase.
Having a share option is not the same as having a share in a company. The exercise of the share option provides you with the right to acquire shares in a company. Upon fulfillment of certain conditions, share options are vested in the employee. The option holder can exercise their right and acquire stocks in the company.
How does an Employee Share Option Plan operate?
ESOPs are used by companies of varied sizes. In closely held companies, ESOP is used to facilitate the planning of succession. Companies generally set ESOPs as trust funds, in which newly issued shares are funded by the company. They may also keep cash to buy existing shares, or borrow money to purchase company shares. ESOP practices, contrary to popular belief, do not discriminate among its employees. The companies that provide share options to their employees are required to appoint a trustee fiduciary to overlook the process. This means that senior employees are not favored unfairly and all ESOP participants hold voting rights.
What are the Tax benefits associated with ESOP?
In the UK, the ESOP schemes that acquire approval from the HM Revenue and Customs (HMRC ) provide tax benefits to both the employer and the employee. As participants of the ESOP do not need to pay income taxes, the ESOP scheme provides a great incentive for its participants. The national insurance contribution associated with the purchase of shares is much lower than the usual market price.
What does an ESOP comprise?
If your company is setting up an Employee Stock Ownership Plan, you should include the following:
- Exercise Price
Through the ESOP, you can offer your employees a set number of options to purchase stocks in the company. They can purchase the shares at a fixed price. The fixed amount is known as the exercise price or the strike price. The exercise price cannot be less than the stock’s market value. The option holders will only get dividend rights and the right to vote when they choose to obtain shares. In ideal circumstances, the share prices will increase before the instance the employee chooses to sell those shares.
- Vesting Period
Employees do not immediately acquire ownership of the option. They will acquire the ownership after the vesting period. The employee will not have the option to exercise the ESOP until it has been officially vested. During this period they do not have the option to purchase any shares or enjoy the rights of being a shareholder in the company. The time frame for the vesting is set out in the ESOP agreement.
- Shareholder Agreement or Deed of Accession
When an employee who has been vested with a share option chooses to exercise their purchase option, they become shareholders of the company. The transition from an option holder to a shareholder will require the signing of the company’s shareholders agreement or its deed of accession. Signing the deed of accession means that the new shareholder agrees to the terms and conditions laid out for the shareholders in the shareholder’s agreement.
- Conditions to lose unvested options
If the employee decides to leave the company they may lose unvested options. You may also require your employee to sell unvested shares to a person who has been nominated by the company. Generally, employees can only dispose of their options if they have the written approval of the board or there is an event of liquidation. An employee’s right to dispose of their shares is dictated via the shareholder’s agreement. Usually, the employee cannot dispose of their option or their shares within the first few years.
- Conditions concerning Liquidation
In the event of liquidation, the company may choose to exercise its discretion. They may choose to buy back vested or unvested options from their employees. The employee can exercise their options, making the sale of the shares a part of the liquidation event. They may also abstain from exercising their options. This will lead to the lapse or expiration of the share option.
If the employee has held their shares for more than three years, they have the right to dispose of their shares in the event of liquidation. If the majority shareholder has decided to sell their shares, they can convince the employee to sell it on the same term.
The tax benefits associated with ESOPs have incentivized employees to enter into share option agreements with their companies. It is observed that most employees choose to exercise their options on the day of the liquidation event in hopes of acquiring profits. Under ESOP, there is a set price at which an employee has the option to purchase company shares. A vesting period is allotted after which the employee may hold the share option. If they choose to exercise their rights, employees will have to sign the Shareholder’s Agreement or the Deed of Accession document in order to transition from an option holder to a shareholder. There are certain conditions for the disposition of the shares that an employee will own through the share option. Usually, such shares are sold during an event of liquidation.
You may also like:
- 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?