Employee share options schemes, also known as employee stock ownership plans, allow employees to hold stock in the firm they work for. Ownership of a share in a corporation entitles the holder to a portion of the company’s assets or profit. Simply put, an employee can become a part-owner of a business by purchasing shares. Plans for employee ownership in the company can help employees and shareholders align their interests. A worker might put in more effort to assist the business to succeed if they own shares there.

Whether your business is a startup, scale-up, or a big organization, you’ll probably need to adopt an employee share option scheme. You need to be well informed to ensure you make the right decision, and here are the considerations.

The size of the option pool

While there is no set size for the ESOS pool, according to market practice, it should be between 7.5 percent and 15 percent of the company’s issued and paid-up share capital. To keep talent on board and manage financial burn, some venture capital investors may require that a company adopts an ESOS as one of their investment requirements

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Founders and investors must formally agree upon the option strategy and the ESOS pool’s cap. A bigger option pool can also be necessary as the business develops and progresses through several funding rounds.

The option price and the exercise price

The amount employees pay the corporation to receive the options is known as the option price. Different jurisdictions may have regulations governing the minimum price for such alternatives, and the pricing may vary. Most often, the options are given either for free or at a minimal cost to encourage employees to accept them.

The exercise price is the sum the employee must pay the corporation to execute the option. This is usually decided at the board’s (or the ESOS administration committee’s) discretion and may be either a nominal value or the shares’ fair market value at the time of grant.

The vesting period

The vesting time specifies how long it will take for an employee to get their awarded options. This usually takes place over three to four years, following a “cliff” period of one year, during which the employee must continue to be employed before any option allocation takes place.

By staging the enactment of the option and rewarding the employee continuously during the vesting period, this strategy protects the company by reducing the danger that the employee may leave with stock ownership that is not proportionate to the time and effort he has contributed to the business.

The rights of underlying shares

Employees will possess shares once their options have been exercised, provided that the exercise price is paid. Market practice varies in the shares issued and allocated to employees due to the exercise of their options. Most often, that would be ordinary shares, although it’s possible that founders don’t want to deal with stockholder voting rights being exercised by lower-level employees.

To resolve this, the regulations of the employee share options scheme may stipulate that by accepting any ordinary shares granted to them, employees agree not to use their voting rights. Alternatively, we have also seen documentation describing the creation of a different class of shares without voting privileges.

Taxes

ESOS gains will typically be subject to taxation, and it is essential to consider how taxes affect employees in various jurisdictions. According to ESOS experts at Sangfor, the business should also obtain guidance on applicable securities regulations if there are staff in several countries. Examples include disclosure requirements for directors who get options.

To meet exemptions from the requirement to release a prospectus for granting such options as an offer of securities, the ESOS may also need to include a few restrictions, such as on the employee’s right to resale. It may also be wise to ensure that the ESOS rules governing such events comply with the relevant jurisdictions from the beginning.

Consequences of an employee leaving the company

In most cases, when an employee leaves their job during the cliff period, they shouldn’t be given any options. When employees resign within the vesting period, they are entitled to several vested options, and as a result, all unvested options will be lost.

The ESOS rules should specify reverse vesting rights over the shares obtained through option exercise (with the existing shares owned by the shareholders) upon any employee leaving the company. This goal ensures that departing employees, especially senior or management shareholders, do not continue to possess significant voting rights over a business they are no longer leading or managing.

Consequences of a liquidity event

An important turning point for a startup would be a liquidity event, usually a trade sale or an IPO. The ESOS regulations would have to specify what happens to vested and unvested options at that point. Vested options are exercised after a liquidity event. Alternatively, it could be within a set period from such occurrence to provide certainty to the buyer or the shareholding structure of a firm on an IPO.

Unvested options should either be expedited and vested right away or should expire upon such a liquidity event. In most circumstances, the acquirer may decide to keep some personnel while eliminating the need for others after the acquisition.

Additionally, the ESOS may be wise to include drag along the right for the selling majority shareholder/founder over the shares held by workers arising from any exercise of the options in case of a liquidity event. This will ensure that minority employee shareholders can thwart such an exit if the founders sell the company.

The takeaway

Consider an ESOS that will work with your company’s ambitions for growth as soon as possible. This motivates the company’s stakeholders to consider the long-term equity structure. The specific type and layout of the plan will depend on the goals the company wants to pursue. Early identification of this goal will assist the business in choosing the appropriate organizational structure.