Many eligible startup employers have implemented Employee Share Option Plans (ESOPs) with their key employees. An ESOP allows employees to receive shares or options in your company. This means your employees can receive a financial benefit via dividends if your company performs well. In this sense, an ESOP can help align your employee’s interests with your company’s financial interests. This article explains what is an ESOP and how an ESOP works.
What is an ESOP?
An ESOP is a scheme where you offer your employees shares or options to acquire shares in your company.
Startups typically have limited capital. As a result, an ESOP is a good way to show your key employees that you appreciate and value their contributions. If your employee accepts an ESOP, you should explain and put into writing:
- how many options for shares you will offer;
- when the shares will vest; and
- the cost of the shares.
What to Include in an ESOP
Most documentation in respect of ESOPs will cover the following matters.
1. Exercise Price
You will generally offer your employee a set number of options to buy shares in the company at a fixed price. This amount is known as the exercise price or the strike price. However, options do not carry voting rights or the right to dividends. Instead, voting rights and rights to dividends are only available if and when the options turn into shares.
When giving the options over to an employee, the exercise price must not be less than the market value of shares in the company. Ideally, before your employee disposes of their shares, they would have increased in value as the business’ performance grows.
2. Vesting Period
The options will vest gradually over a set period. This means that ownership of the share options will not be given to you immediately but over a long time.
You should note that an employee cannot exercise an option until it has vested. As such, an employee cannot purchase shares in your company until the option has vested following the time frame you set out in the ESOP agreement.
3. Enter into a Shareholder Agreement or Deed of Accession
If an employee decides to exercise the purchase option by buying the agreed number of shares at the exercise price, your employee will then hold shares in the company.
As your employee will now be a shareholder and no longer an option holder, they will need to enter into a shareholder agreement or a deed of accession. A deed of accession confirms that the new shareholder agrees to become bound by your company’s existing shareholders agreement.
4. Losing Unvested Options
It is not unusual for employees to lose unvested options if they leave the company. If this occurs, you can require your employee to sell any unvested shares to a nominated person for a fair amount that you determine.
In saying that, you cannot dispose of any options or shares within the first three years unless you experience some specific circumstances, such as your employee leaving. Otherwise, your employee may lose the tax concession.
Usually, an employee cannot dispose of options until a liquidation event unless they have your board’s written approval. In any event, the treatment of any share disposal will depend on the terms of the shareholder agreement.
5. Liquidation Event
If there is a liquidation event, your company may exercise its discretion by:
- buying back any vested or unvested options from your employee; or
- notifying the employee that all of their options have vested.
Your employee can:
- exercise their options so the share sale can be part of the liquidation event; or
- choose not to exercise their options, meaning the options would lapse or expire.
If there is a liquidation event and the majority of your shareholders decide to sell their shares, they can compel your employee to sell all of their shares on the same terms as the majority shareholder. This is because your employee has held their shares for more than three years since you issued the options.
Continue reading this article below the formTax Concessions for an ESOP
Before July 2015, an employee who entered an ESOP had to pay tax when they received those shares or options even if they had not received any financial benefit from the shares or options. That means an employee was liable to pay tax each time the shares were vested even if they did not exercise their purchase option to pay for the shares.
Under the new system, employees will now only pay tax on their shares or options when they receive a financial benefit. Namely, when your employee sells the share. If you issue shares to your employees under an ESOP, they can defer tax until they exercise the share option to convert and realise financial benefits. Additionally, employees have up to 15 years to defer their tax liability.
LegalVision’s Employee Share Schemes Guide is a comprehensive handbook for any startup founder or business owner looking to attract and motivate top employees with an Employee Share Scheme.
Key Takeaways
In practice, many employees exercise their options on the same day as a liquidation event and hopefully receive a profit. The changes to the tax treatment of ESOPs have made it more attractive for employees to enter into them with their companies. If you are interested in offering your key employees options in your company using an ESOP, our experienced startup lawyers can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
An employee share option plan or ESOP is a scheme that allows your employees to receive shares or options in your company.
An ESOP can help employers retain their key staff. This is because ESOPS allow your employees to receive financial benefits when the company performs well.
We appreciate your feedback – your submission has been successfully received.
