ESOP: FAQs
An employee share option plan (ESOP) is a scheme that invites employees of a company to become co-owners. The transition from employees to co-owners will take some years. The employees may also need to make some payments (to both the company and the IRD). Putting in place an ESOP is completely voluntary. So we ask:
Should you have an ESOP?
How does it work?
What if an employee does not exercise the options?
What happens when someone leaves?
What happens when you sell the company?
Are there alternatives to an option scheme?
1. Should you have an ESOP?
There are several reasons why you should have an ESOP. First, there is a very good business case for it. One UK government study found that employee-owned businesses have a strong long-term focus with greater employee commitments. A 2021 research published in the Harvard Business Review reported very similar findings. Businesses with 30% or more employee ownership are more productive, grow faster, and are less likely to go out of business than their counterparts. Companies that invite employees to be, and so think like, owners saw the largest performance benefits. These findings are not surprising.
The second reason is employee reward. Today, businesses need to reward employees in ways other than just cash. Yes, cash is king, but we are now looking at a complex labour market with many different rewards, benefits and drivers. ESOP is one of these key benefits that make a company stand out from its competitors.
Another reason is that an ESOP makes a company more attractive to investors. Investors in early-stage growth companies expect the founders to have an ESOP pool. The investors appreciate the benefits of businesses with employees with owner mindsets. They want to see employee ownership at work. Anywhere between 10% and 20% of the diluted share capital of the company should be set aside for ESOP. Having a well-considered ESOP in place makes the company attractive for investment.
2. How does it work?
An ESOP is an “option” scheme. The company grants participating employees call options to buy shares in the company. The options vest over time, around 3-4 years with an initial cliff period. The options may be subject to performance conditions too.
Once options vest, they become exercisable. On exercise, options convert into company shares. When a participant exercises the options, they will need to pay the exercise price (if any) and also consider paying income tax to the IRD. The exercise price is typically the market value of the shares at the time of grant. But it can vary depending on how you want to incentivise your employees. On exercise, the participant must also enter into the company's shareholders’ agreement. (Please see our article on shareholders’ agreement FAQ). This is the preferred employee share scheme structure in New Zealand under the current tax rules.
An ESOP is generally administered via two documents. The rules apply to every participant. They set out how the options are granted, vested, exercised and cancelled, and how the company may buy back shares issued under the scheme. The ESOP rules will make it clear that the board has the discretion to interpret, enforce and amend the rules, subject to some protections for the participants.
The second document is a personalised invitation letter or a participation deed. This document contains individualised terms of the ESOP for each participant. They include the number of options granted, the vesting period and conditions, the exercise price and the exercise date. These do not have to be the same across the border for all participating employees. The invitation document should contain all prescribed information under the Financial Markets Conduct Act 2013 and its regulations.
3. What if an employee does not exercise the options?
The participant has an “exercise date” by which he/she must exercise the options. The exercise date is typically 5 to 10 years from the date of the grant. The options will lapse if they are not exercised by the exercise date.
So why would a participant not exercise an option? This may be the case if the option is “underwater”. That is, the exercise price is more than the value of the share at the time of exercise. This is very unlikely with fast-growing tech companies, but it is possible.
Another likely reason for not exercising an option is the tax consequence. Income tax payable on the exercise of options can be substantive. In New Zealand, the participant has to pay income tax on the difference between the market value of the shares and the cost of exercising the option. So participants tend to delay the exercise for as long as possible, for example, waiting for an exit event. This may often extend beyond the exercise date and result in lapsing of the options altogether.
4. What happens when someone leaves?
Suppose an employee that participated in an ESOP leaves the company. A few things can happen to the options:
Unvested options. Any options that have not vested lapse immediately whatever the circumstances.
Vested options + Bad leaver. If options have vested and the employee leaving the company is a “bad leaver”, the options generally lapse immediately.
Vested options + Good leaver. If options have vested and the employee leaving the company is a “good leaver”, then the participant may exercise the vested options for a short period. For example, between 30 to 90 days after the departure. Vested options may continue until the standard expiry date (5-10 years) but this is not typical.
Options exercised and converted into shares. The departing employee may have already exercised their options into shares. Those shares should remain with the employee. But, ESOP rules can provide for clawback of those shares under specific circumstances. For example, where the employee is a “bad leaver” such as joining a competitor, the company may have the right to repurchase the shares.
These are subject to board discretion and individual wording of the ESOP rules.
5. What happens when you sell the company?
A company may be sold, get listed on a stock exchange or face similar “exit events”, while it has employees who have unexercised options. What happens next depends on the ESOP rules, including the board’s discretion. For example, the ESOP rules can “accelerate” unvested options so they become exercisable by participants before their vesting dates. Or, all unvested options may lapse immediately before the closing of the exit event. The board may also set a date for the participants to exercise their vested options or else have those options lapse.
A typical feature on exit is “cash settlement”. This happens where, for example, all the shares in the company are being sold. The board may cash settle all outstanding options by treating them as shares as part of the sale. The employee will then be paid for the sale of the shares, minus the exercise price.
6. Are there alternatives to an option scheme?
Two key alternatives are a share purchase scheme and a phantom share scheme. Under a share “purchase” scheme, the company issues shares to the participants on agreed periods or on the basis that those shares vest over time. The participants often get a loan from the company to pay for the shares. One key disadvantage of this structure is tax implications. The employees may have to pay income tax on the value of the shares they receive (minus the price paid), with a layer of complexity if there is a company loan. In comparison, an option scheme delays the taxing event until the participant exercises the options.
Another structure is a phantom share scheme. The company gives non-equity, cash bonuses to participants based on the share performance of the company. They are exposed to the economic upside in the company’s value but are not legally interested in the underlying share capital. That is, the participants do not become shareholders of the company. Phantom schemes are appropriate where a company does not have the approval of the shareholders to issue employee shares or options or has exhausted its ESOP pool.
If you are thinking about putting in place an ESOP or have any other questions, please feel free to reach out to Josh Woo, or let us know.
Disclaimer
This publication should not be construed as legal or tax advice. It is necessarily brief and general in nature. Please seek professional advice before taking any action in relation to the matters discussed in this publication.
