Should I Offer my Employees an Employee Stock Option Plan (ESOP)?

In today’s hyper-competitive labour market, start-up companies are often at a disadvantage compared to big corporations because they can’t offer the type of lucrative compensation packages that their cash-flow rich counterparts can.  

As a result, start-ups that are low on cash have to be more creative when it comes to hiring the best talent in the labour force. But if they can’t offer high salaries, what can they do to attract and convince top talent to join them?  

In this article, we’ll discuss how you can use an Employee Stock Option Plan (ESOP) as a tool to improve your employee compensation package without straining your cash flow.

We’ll explain what ESOPs are, their advantages and disadvantages, how they're structured, how they differ from an Employee Share Ownership (ESOW) plan and much more.

What are ESOPs?

ESOPs simply grant your employees the right to purchase shares of your company at a pre-determined price within a given time frame.  

Companies set aside a certain amount of equity for an ESOP into an Employee Stock Option Pool (ESOP Pool), normally between 10-15% of the total shares, and determine the price at which employees enrolled in the plan can purchase the shares. This pre-determined price is known as the exercise price.

How are ESOPs Structured?

The first step is to create an ESOP Agreement that creates the aforementioned ESOP Pool and an ESOP committee. The committee is responsible for managing the ESOP Pool and recommending relevant actions to the company’s Board of Directors. Members of the committee generally include directors and other senior staff of the company.

Next, you can include a vesting period and/or a cliff period in your ESOP. A vesting period means that an employee will receive the promised number of shares over time. If an employee leaves during this period, (s)he will receive pro-rated stock options based on how long (s)he was employed at the company.

For example, if you give Bob 40,000 shares as part of his ESOP package and subject him to a 4-year vesting period, he can only exercise 10,000 shares per year. After the vesting period, Bob can exercise up to 40,000 shares.

In addition to the vesting period, you have the cliff period. If Bob has a 1-year cliff period, then he must remain at the company for at least 1 years before he can exercise

his ESOP, ie, 10,000 ESOP will be available for Bob to exercise the day after his 1st year anniversary at the company. Your cliff and vesting periods depend on how quickly you expect your company to grow, how long you want employees to commit to your company before they receive their shares, and your company’s financial position.

Finally, you can add a selling restriction to your ESOP. This means that there’s a period during which employees cannot sell their shares. If you impose 1-year selling restriction, for example, your employees cannot sell the shares they received through the ESOP for at least a year after receiving them.

Given the complexity of forming an ESOP, we strongly recommend hiring a lawyer or ESOP expert to assist you from start to finish.

What are the Tax Implications?

As an employer, you receive tax deductions on any costs incurred to acquire your company’s shares for the purpose of transferring them to employees under an ESOP. You receive these tax deductions as long as the ESOP falls under the Qualified Employee Equity-Based Remuneration Scheme (QEEBR).

Employees will be taxed on any gains they obtain when they exercise their share options. For example, if the market price per share is $1 and they exercised the option at $0.60 per share, then they’ll be taxed on the gain of $0.40 per share as part of their employment compensation.  

When and how these gains are taxed depends on several factors:

  • Gains from an ESOP without a vesting period are taxable in the year that the shares are granted.
  • Gains from an ESOP with a vesting period are taxable in the year that the ESOP is exercised if there is no selling restriction.
  • For ESOPs with a vesting period and a selling restriction, the gains are taxed only in the year in which the selling restriction is lifted.

What are the Advantages & Disadvantages of ESOPs?

The main advantage of an ESOP is that it allows start-ups with little cash flow to offer attractive compensation packages to prospective employees. This way they can compete with big corporations even if they can’t offer equivalent salaries.

Another advantage is that if you include a cliff and/or vesting period in the ESOP it creates long term alignment with your employees beyond the monthly salary and annual bonus, This is because the more successful and valuable the company becomes, the shares will be valued more when they exercise their ESOPs.

For example, David Choe, a graffiti artist that first spray painted the walls of Facebook’s headquarters in 2005 received his payment entirely in shares. Later on, Choe proceeded to continue working with Facebook and decorating their new office branches as they expanded their operations. Today, Choe’s shares are worth over $200M.

A key disadvantage of an ESOP is that they are only viable for companies which have institutional investors, heading for an IPO or is publicly listed. This is because employee will not be able to easily cash out of the shares unless the shares are publicly traded or the company is sold.

Another disadvantage is that an ESOP can become increasingly complicated over time as you have to track the awards to different employees which have different vesting periods and exercise price.

Sprout with Us!

Sprout offers professional corporate services to businesses just like yours with the help of our team of experts! Implementing an ESOP is an important business decision that requires time and effective communication. To ensure such matters are handled thoroughly, Sprout offers budget-friendly corporate secretarial services to accurately manage the repetitive and time-consuming aspects of running a business. Additionally, Sprout can help you with the execution of your ESOP or connect you with ESOP experts who can provide advice on the best ways to structure your ESOPs. Any questions? Feel free to contact us with any of your queries, we’ll respond within 24 hours.