What are ESOPs and what benefits they provide to businesses
To grand an option is one of the ways to motivate employees. Under an option, an employee acquires a right to obtain, under certain circumstances, an equity interest in the company. Basically, this means that such employee acquires some shares of the company or a right to receive a portion of profits in case of successful sale of business. Thus, an option does not always imply acquisition of shares, however option’s earning capacity is always linked with the development of business.
What benefits options provide to businesses?
When an employee acquires an equity interest in any form whatsoever, he/she is motivated to contribute to the development of such business as if it were his/her own business. Accordingly, such business will grow faster, as more people have a direct interest in this growth.
How do employees actually benefit?
When an option is executed, an employee may obtain the following benefits:
1. Employee may sell stocks or receive portion of profits, for example, in case of full or partial exit.
Thus, at the initial stage of company development, an employee may under an option acquire a right to 100 stocks worth 1 US dollar each. In a couple of years, one company stock will be worth 100 US dollars, and the employee will sell his/her 100 option stocks s at the price of 10,000 US dollars. The total pretax profit will amount to 9,900 US dollars.
2. Employee will be able to receive dividends, however, this is peripheral, as, firstly, dividends are distributed (basically) quite rarely, and, secondly, the percentage of employee’s stocks and respective dividend share will be quite small.
3. An option does not actually provide an ability to exercise control, as (according to normal market practice) option stocks will not empower an employee to participate in rendering crucial decisions.
At which stage of development may a company introduce an ESOP?
1. Startups often use ESOP, where they do not have enough resources to engage costly specialists. At this stage, employees have great chances to acquire stocks at a low price, however risks are most high as well (as prospects of company development are vague).
2. More mature companies also introduce ESOP. Motivation, during this stage, is the same: the company continues growing, and the employee will be able, in future, to sell stocks with a certain earning power. At this stage, employee’s risks are lower, as company’s prospects are clearer, however the prices of stocks will be higher.
3. Companies that went public may introduce ESOP as well. As benefits for their employees such companies can, for example, offer bonus stocks where an employee buys a certain number of stocks at the stock exchange at market value.
What exactly is an ESOP?
From legal point, an ESOP is a certain set of documents comprising primarily of:
- an option plan (ESOP) itself, specifying all ESOP’s terms and conditions,
- an agreement with a particular employee specifying particular terms and conditions for each particular employee (specific number of stocks, vesting schedule, and others).
What should ESOP stipulate?
Basically, an ESOP/agreement with employee should stipulate at least the following terms and conditions:
1) What employees actually get: real freely transferable stocks or a right to participate in profit in future. Normally, this is subject to whether the company intends to make a certain employee a full participant of its business (a decision-maker), or to limit employee’s motivation by monetary means only.
2) Who will be entitled to participate in ESOP: many jurisdictions allow granting options not only to employees, but to contractors as well.
Moreover, you can establish any criteria for employees/contractors participating in ESOP:
- employees holding certain positions in the company,
- who have been with the company for a certain number of years, and others.
3) Also, it is important to specify: whether all qualifying employees participate in ESOP, or each particular employee has to be approved by the board. The first variant is relevant for very big companies where members of board do not know each employee in person.
4) When ESOP may be executed.
It is important to realise that obtaining an option and execute an option are different things. Thus, obtaining an option implies the conclusion of an agreement only, while execution an option involves actual transfer of stocks or a right to profit-sharing to employee. Normally, when an option agreement is being concluded, an employee does not immediately obtain stocks, but such agreement only establishes employer’s obligation to transfer a certain agreed number of stocks to employee in future under certain contracted terms and conditions (for instance, provided certain KPIs have been reached).
5) Cliff and vesting.
Vesting is established to motive employees to continue working in the company. Vesting is a period within which the employee is entitled to execute the option. Often, an option may be executed within such period by parts, as various terms and conditions stipulated by the agreement occur. The standard vesting period is 4 years, including 1 year for the ‘cliff’ (a period from the date of conclusion of an agreement and till the date of empowering the employee to execute the first portion of the option) and 3 years for ‘vesting’.
For example, you have promised an employee 4,800 stocks, upon condition of 1 year cliff and 3 years vesting. In 1 year your employee will “obtain” 25% of stocks, 1 year later – another 25%, and so forth. Basically, within the vesting period stocks are “granted” once per months/quarter (that is, accordingly, 1/12 of all promised stocks each month or 1/4 each quarter). In 4 years, your employee will be able to obtain all 4,800 stocks.
If an employee leaves the company before the expiration of 4 years, then, if the KPIs are met, he can get some of the stocks promised to him/her. But only that number, the vesting of which has already occurred. Although it is also possible to provide that the employee loses the right to exercise the option upon termination of employment.
Also, there is accelerated vesting, where an employee may obtain stocks faster than initially stipulated. It requires a certain trigger – and most often company sale is such a trigger. For example, you have a vesting period of 4 years, however you have agreed that in case of company sale within the next 2 years, employee will obtain all stocks (that is, earlier). This is beneficial for employees, as he/she is motivated to work better to enable the company to attract an investor faster. However, this is not beneficial for an investor, as an investor acquiring a company needs company employees to continue working. However, once the employee has already obtained all option stocks by way of an accelerated procedure, this kind of motivation will not work for him/her, and the investor will need to grant another option or choose other employee retention program.
6) Stocks purchase price.
An option does not always imply that an employee receives stocks free of charge (as stated above, an employee is motivated by other reasons).
You may grant stocks free of charge or at a price below market value, however this might entail tax consequences for both employee and the company. Legislation of some countries basically prohibits transfer of stocks under certain types of options at a below the market price. The optimum alternative is transferring stocks to employee at a market value.
7) Can an employee sell stocks after receiving them.
Any business strives to control its shareholders, otherwise competitors may penetrate. This and other reasons set certain restrictions for employees in terms of managing stocks, such as:
- employees may sell stocks, however only upon company’s consent, and the company shall have the pre-emptive right to buy-out any and all stocks,
- employees may sell stocks only under certain circumstances (full exit),
- employees may sell stocks only upon expiry of a certain time-frame.
8) What happens to stocks after employee’s dismissal.
Where an employee quits your business, you may not be interested to have an alien person among your shareholders. That is why you may stipulate in advance, that in case of dismissal you company shall buy-out all employee’s stocks, or the employee shall keep the stocks subject to all stipulated sale restrictions.
This is a minimal set of terms to be stipulated in an option agreement, regardless of jurisdiction, however it may be augmented to a scope fitting your business.
Can employees of Belarusian companies participate in ESOP of foreign companies?
This situation is quite topical for Belarusian companies having foreign parent companies. Often, foreign parent companies desire to expand their ESOP onto employees from all jurisdictions, including Belarus. Can Belarusian employees participate?
The answer is: yes, they can, however you must make sure that the ESOP proposed by a foreign company does comply with Belarusian legislation. For example, such ESOP often stipulates that the price of stocks to be transferred will be withheld from employee’s salary, however this is by no means always possible in accordance with Belarusian law (there are some restrictions with respect to grounds for withholdings, withheld amounts, etc.).
Where a Belarusian employee (or a resident of the Republic of Belarus) has obtained an option from a foreign company, once it has been executed, it is important to make sure that various regulatory requirements have been met. The crucial thing is, of course, tax payment. Tax consequences, normally, occur when dividends are received or when stocks are sold. Also, tax implications may take place when stocks are being acquired (where employee receives stocks free of charge). Anyway, an employee must notify a local tax inspectorate of acquiring stocks of a foreign company within 10 business days.
Can Belarusian company grant options to its employees?
Yes, the Belarusian legislation does provide norms allowing doing that. Thus, Hi-Tech Park residents were granted the right to provide options already in 2018, and 2021 saw the promulgation of a dedicated norm allowing all Belarusian employers to provide stocks to employees (see detailed information on providing options to employees of Belarusian companies here: https://www.mondaq.com/article/1070796