ESOPs: a comprehensive guide to Employee Share Ownership Plans updated for 2021

ESO Ps explained

Employee Share Ownership Plans (ESOPs) are gaining in popularity as awareness of their benefits increases. In this comprehensive ESOP guide we’ll explain:

ESOP grants for staff

ESOP grants for employees help to create a sense of ownership in the business.

How does an ESOP work?

There are a range of different ESOPs that will suit different businesses and each type of ESOP works differently. Here are four main types of ESOPs with an explanation on how each of them works:

Call Option Plans (often called Employee Share Option Plans)

In a call option ESOP scheme, the employee is granted options which gives them the right to buy the company's shares at a specified price and date within a specified period of time. Call options can be earned through staying a certain amount of time with a company or based on performance, or potentially a mix of the two.

Call option plans are often favoured by companies who are still building a sustainable cashflow and need to carefully manage salary costs, where staff may not be in a position to purchase shares, or the future of the company is hard to anticipate.

Early stage investors will often request that an options plan is implemented prior to their investment, as they recognise their potential value for the company. More mature companies can also benefit from options plans particularly when they are heading toward a sale or liquidity event.

Loan to Purchase

A loan to purchase scheme will typically be used to immediately ‘sell’ ownership of shares to employees at market value. Usually the company will either offer a low or no interest loan to employees to fund the purchase of the shares. Loans will often not require repayment until such time as an eventual liquidity event in the company.

Loan to purchase schemes are often favoured by more established companies, and a trust entity could also be established to hold shares for employees in the parent company- these are often referred to as Employee Share Trusts.

Phantom or Bonus Share Schemes

A phantom share scheme will provide employees with a contractual right to a monetary amount on certain events occurring or certain objectives being achieved. In this scheme, the company agrees to pay a future cash bonus equal to the value of a defined number of shares. There is usually no legal transfer of share ownership, although the phantom stock may be convertible to actual shares if defined trigger events occur, such as when dividends are calculated and/or a liquidity event occurs.

Phantom share schemes create some of the benefits of formal share ownership without requiring the physical transfer of shares or options, and are frequently used in businesses with a strong profit share focus.

Management Buy-Outs

Whilst not always classed as an ESOP, management (or managed) buy-outs can be used as an option for succession planning for a business. A management buyout scheme creates transactions where a company’s management team or senior staff purchase the assets and operations of the business they manage over time.

They create another way to incentivise key staff, particularly in more long standing or profit-driven companies. A management buyout is appealing to professional managers and seniors because of the greater potential rewards and control from being owners of the business rather than employees. For the original owners, it can also create a way to exit their business over a period of time in a controlled way.

Company documents

ESOPs can benefit both employees and the company, but need to be well documented so everyone is on the same page.

Are ESOPs good for employees?

ESOPs give employees the opportunity to have a direct stake in the company’s success through their shareholdings. They are likely to feel motivated to be fully productive and build sustainable value because they own a stake in the company and have a vested interest in the long-term success of the business.

ESOPs can be offered widely so they don't just benefit a lucky few, and even having an ownership scheme can be reflective of a good business to work for. A long-term survey which has tracked workers since 1997 showed that those working at companies with some employee ownership have had consistently better jobs and benefits and higher wages and wealth, regardless of the industry they work in.

Depending on the scheme, ESOPs can provide employees with a way to potentially make impressive returns in a tax-efficient way, usually without having to find the means to pay a large lump sum payment upfront. For example, the employee may not need to pay tax on options until they've gained a financial benefit from them either at the vesting or exercising stage.

Are ESOPs good for employers?

ESOPs can be a highly effective mechanism for engaging staff. They can be an excellent way to recruit the best talent in an increasingly integrated global economy where there is worldwide competition for top candidates.

ESOPs incentivise employees to help the company grow and succeed because they can share in its success, and focus on longer term company goals rather than short term personal goals. They can help to retain key staff within a business - companies with ESOPs have reported less employee turnover compared to their industry average.

In these uncertain post-Covid times, ESOPs can be particularly beneficial for companies. Many may be feeling cashflow pressures, and yet the need for skilled and loyal employees has perhaps never been so high. ESOPs can help to ease this pressure by offering employees options rather than cash incentives, easing pressure on the business’ cashflow.

Research from Rutgers University found that during and after the 2008-9 financial crisis, companies with ESOPs in place had much higher sales growth compared to companies with no employee ownership in place, and that those with ESOPs outperformed those without during the COVID-19 pandemic in the areas of job retention, pay, benefits, and workplace health and safety.

Given that organisations with the most engaged employees have been found to have higher productivity, higher customer engagement, better retention and an average of 21% higher profitability, the benefits of ESOP schemes can soon outweigh the costs of implementing and managing them.

ESOPs have been found to also benefit companies by:

  • improving workplace culture & job satisfaction

  • boosting profitability

  • increasing customer loyalty through improved service

To support succession planning in a business, ESOPs can also be used as part of a potential exit or sale strategy for current owners to eventually pass ownership to staff members using the managed buy out method above. Employers have the advantage of managing the transition process, and transferring ownership to a buyer they can entrust with the future of the company.

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How to set up an ESOP

ESOPs are often perceived as complicated, and unfortunately this may deter not only Founders, CEOs and CFOs from setting them up, but it can also discourage the Finance or HR team from fully utilising them as a staff incentive, and prevent employees from fully engaging with their ESOP.

The first step to setting up an ESOP is to decide on your objectives for the scheme, including creating an ownership mindset with staff, or supporting retention goals. Then the type of ESOP to implement needs to be selected. Common ESOPs such as Call Option plans, Loan to Purchase schemes and Phantom Share schemes can appeal to different companies depending on their size, maturity and structure.

Companies should speak with a lawyer or professional service provider to help decide which scheme structure would suit their business. The details for the chosen scheme can be drafted once key information has been confirmed including:

  • The percentage of company equity for the ESOP pool

  • Plan rules (or deed) including the process for employees who leave and what happens in the event of a business sale

  • Vesting structures including cliffs, frequency and schedule

  • Exercise price (also known as Grant price or Strike price)

  • Expiry dates

Click here for a Glossary of ESOP terms

It is beneficial for companies to have clear details in the ESOP rules on the scenarios for employees who leave the business. Some typical practices are covered in the below scenarios:

ESOP Scenarios for Leaving the Business

ESOP schemes need to consider the different scenarios for when employees leave the business and what happens to vested and unvested shares.

An offer is made to employees or contractors through an ESOP Offer Letter, which will normally be attached to an ESOP Deed which all participating employees must agree to. The Offer creates a contract between the company and employee, which obliges the company to issue new shares to the employee in the future at a specific price and time frame specified by the contract.

How much equity to give in an ESOP

Whilst it is ultimately up to the decision makers of the company to decide the amount of equity being allocated for employees, there are some commonly used calculations which many businesses use as a framework.

A business may have multiple rounds of external financing and often a new ESOP is created each round. As a result, it is critical to not allocate too much or too little equity in each round.

With each new ESOP and funding round, the previous ESOPs become diluted. Not all will vest due to workers leaving the company or failing to meet performance-based vesting requirements, so as a result, the percentage of total employee ownership at an exit can differ significantly.

Below is an indicative framework of ESOP equity at different funding rounds. It assumes additional ESOPs are created at each round and the overall ESOP pool is increased each time. With dilution and unvested options, a typical company may have around 10-25% ESOP at the point of exit:

ESOP pool rounds

The ESOP pool as a percentage of total company equity will vary for different funding rounds.

How to split ESOP allocations across employees

Once an ESOP pool has been created, companies can decide which employees to invite to participate in the scheme. Some companies reserve allocations for top tier positions, while other companies opt to give all of their employees some equity.

As a general guide, employees at the same level should be offered the same range of shares. Here is an example of a commonly used structure which assumes all staff are earning a relatively equal market salary:

Splitting ESOP allocations across employees

ESOP allocations across employees depends on the company approach, their job level, and the funding round.

The ESOP lifecycle- vesting, exercising, expiring & liquidity events

After the ESOP set-up, allocation and grant process has been finished there are key milestones in the ESOP process. The below process is typical for an ESOP scheme using call options:

ESOP call options process

Vesting call options:

Under a call option plan, the option cannot be converted into a share until the option has vested. Vesting normally takes the form of automatic time-based vesting or manual/performance-based vesting, or a mix of both.

Automatic or time-based vesting can either occur by way of a periodic vesting, the use of a cliff or both:

  • Using a Vesting Cliff, a certain amount of options vest after an initial period has passed. For example 6 months worth of options will only vest 6 months from the start of the option plan grant.

  • Using Periodic Vesting, the options vest gradually over a period of time (generally monthly, quarterly or yearly).

For manual/performance-based vesting, options will vest on the achievement of some defined milestone or performance hurdle, or sometimes at the time of granting. If the options don’t vest (for example, because the milestone is never achieved), they lapse and they can no longer be vested or exercised by that employee. They can then be recycled back into the option pool, where they can be allocated for other employees or other offers.

Orchestra ESOP grant and vesting graph

An example of ESOP grant and vesting visualisation in Orchestra.

Exercising call options

After options vest, they can be exercised by the employee purchasing shares at the price agreed in the offer documents. Once an employee exercises options they become a shareholder in the business and are entitled to the same rights as other shareholders.

The Exercise Price is also referred to as the strike price, and is what the employee pays if they choose to exercise their options.

Expiry of call options

The exercise period means the period in which an employee can exercise their options. If share options expire without employees exercising them, then they can then be placed back into the option pool. Expiry dates also need to take into account rules for employees that may leave the business either on good or on bad terms.

Liquidity Events

A liquidity event is an acquisition, merger, initial public offering (IPO), secondary trading or other action that allows shareholders in a company to cash out some or all of their shares.

For ESOPs, the option plan deed will contain information relating to what happens in a liquidity event for the company, including whether unvested options automatically vest or expire.

ESOPs and Tax

For tax guidance on ESOPs, companies and employees should take advice from their lawyer or accountant as there are different requirements across the type of schemes and across countries and territories.

For ESOPs in many countries, tax is calculated on the benefit when an employee is given shares by their employer for free or they purchase them at a value below the market price. The difference between the market value of the shares and what the employee paid for them is considered taxable income, the same way that a cash bonus would be.

Companies in many countries are required to report any taxable benefit received by an employee under an ESOP in the employer's employment income information through their payroll system.

When ESOPs should be implemented

ESOPs can be implemented at any time to support employee packages or staff engagement initiatives. However, many growth companies implement new ESOPs at the same time as they close funding rounds. By doing so they can anchor the employee share option exercise price to the agreed share price of the funding round.

How to engage employees with their ESOP

In many cases the individual responsible for implementing a company's chosen ESOP may be the only person who fully understands it. Often employees don’t have easy access to key documents pertaining to the structure and rules of an ESOP, let alone have full comprehension of their individual role in it.

The key to an efficient and effective ESOP is visibility and understanding. Most employees will not do their own due diligence around the specific rules governing their options. To combat this, some companies will give regular ESOP presentations to their staff. Having those staff regularly view their options and vesting schedules on a system like Orchestra promotes better comprehension and engagement with an ESOP. Some proven ways to ensure employees understand and are motivated by their ESOP:

  • Make sure employees know who to ask if they have questions

  • Keep communication clear and consistent

  • Ensure employees have easy access to relevant ESOP documents

  • Provide clarity of ESOP rules and requirements

  • Use a platform where employees can view their shares and options

Once an ESOP plan has been implemented, it's important to keep all employees involved in the process. The company must ensure that staff have access to their individual ESOP status, including upcoming vesting events, key records, and grant history. Without regular viewing of their ESOP employees often let the incentive slip to the back of their mind. Employees are more likely to login and access relevant information by using a cloud-based platform like Orchestra, which will help to reinforce the all-important ownership mindset.

Contact the team at Orchestra for a free consultation on how to get the most out of an ESOP.


Related articles:

ESOP assessment- which ESOP is right for you?

Using call options for your ESOP

Vesting explained

DISCLAIMER: This article is for informational purposes only, and contains general information only. Orchestra is not, by means of this information, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This information is not intended as a recommendation, offer or solicitation for the purchase or sale of any options or shares.

About the author: this article was written by David Procter in collaboration with the Orchestra team of ESOP and equity management specialists. Dave has worked for companies running employee share schemes for more than 20 years, and has experienced the value they can bring to both employees and employers. Dave lives in Auckland, NZ, with his family.
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