What is ESOP and How Does It Work?
6 minute read
Employee Share Ownership Plans (ESOP) are mechanisms devised for companies with the aim of offering their employees the right to buy shares in the company. They can also be a specific percentage of shares. These employee owned shares come at a specific price which is called the exercise price, and they are valid during a specified period which is called the exercise period.
But how can we further define the Employee Stock Ownership Plan (ESOP)? And how does it work? Read on to learn more about employee stock ownership plans.
Why Are ESOPs Popular?
As it was said above, the exercise period allows the employees to use or not use the given employee stock options at a price determined by the company at the time of the grant. Keep in mind that this is just an option, it is not mandatory in any way.
On top of that, keep in mind that there is no universal rule on how large the option pool should be. A company determines that.
What does this bring to employees interested in exercising the right?
From an employee’s perspective, they expect to make a profit equivalent to the difference between the future valuation of the company and the exercise price.
On the other hand, companies see this as a useful method to reward and motivate key and loyal employees to stay in the company, by granting them equity interest to share any future growth in profits.
Employee Stock Ownership Plan, to some, is an alternative method to incentivize and motivate key performers and talent. In simpler terms, private companies choose employee stock options rather than higher salaries or other forms of monetary remuneration.
ESOP is, thus, quite popular with startups and early-stage businesses that are limited when it comes to financial resources.
Finally, Employee Stock Ownership Plans can be divided into a few vesting option periods. Know that there is a common practice to impose a 1-year cliff during which the option cannot be exercised (this is designed to provide both the company and the employee enough time to see if they wish to commit to each other for a longer period of time).
Who Can Benefit From ESOPs?
Know that an Employee Stock Ownership Plan does not necessarily apply to employees only. It can also be granted to:
If there is obvious potential in the company, these individuals can take advantage of the option too.
Benefits Of ESOPs
We will examine this issue from two points of view:
- ESOP employee benefits
- ESOP company benefits
The ESOP benefits employees since company contributions are provided on a yearly basis to the Employee Stock Ownership Plan (both cash and stock).
These benefits are allocated to the accounts of participating employees in the trust created as part of the Employee Stock Ownership Plan. The accumulated balance in a participant’s account is distributed to the participants following their retirement or other forms of employment termination.
Keep in mind that the value of the ESOP benefits account is not taxable to the employee as long as the account stays in the ESOP trust.
On the other hand, companies benefit from an ESOP when it is used as a method of corporate finance as well as an employee benefit plan.
Corporate ESOP benefits cover:
- Raising new equity capital
- Refinancing outstanding debt
- Acquiring productive assets using cash borrowed from third-party lenders
ESOPs can also be used to improve cash flow by making plan contributions in company stock contrary to cash.
Considering that the ESOP contributions are fully tax deductible, a company can fund both the principal and the ownership interest payment on an ESOPs debt service with pre-tax money.
Keep in mind that dividends on ESOP stock are tax deductible if they are used to repay ESOP loan principal – the proceeds of which were used to obtain the employer securities regarding the dividends that were paid.
Finally, let’s go through some frequently asked questions and common uncertainties people have regarding the ESOP.
How big should my option pool be?
There is no general rule that stipulates how big the option pool is. However, in most cases, this figure stands between 8% to 20%.
Is ESOP regulated in Hong Kong?
If we were to look at this issue from a practical point of view, the Employee Stock Ownership Plan can be compared to dealing with the sale of securities.
This activity is regulated under the Companies Ordinance which stipulates numerous restrictions regarding the publication and sale of securities to Hong Kong investors.
However, ESOPs belong to a category that is exempted and there is no specific regulatory requirement or restriction taking that the offer of securities is made to the four categories of beneficiaries (employees, directors, officers, and consultants).
What is the tax treatment of ESOP in Hong Kong?
You will probably be glad to hear that there is no tax imposed on the grant of such a stock option plan. This is one of the great tax benefits in Hong Kong.
However, salaries tax applies when an employee exercises the option. Both the company and the employee are required to report such an amount to the Inland Revenue Department for tax calculation purposes.
Luckily, the ESOP is not seen as a relevant income for MPF purposes. Keep in mind, though, that employees based overseas that exercise their ESOP option may also be subject to salaries tax in the foreign jurisdictions.
How do I set up an ESOP?
To do this, the ESOP has to be adopted at the shareholder’s levels during the annual general meeting. Next, it needs to be approved by the board of directors. Once the plan is adopted, the company has to issue an Option Certificate.
This certificate lays down the terms and conditions of the Employee Stock Ownership Plans. Usually, an ESOP is formed on a first or second investment round when investors make clear their expectation that the executive team has to be fully and properly resourced.
The Employee Ownership Plan is a plan that can bring great benefits both to companies and employees.
Even though companies in various parts of the world (Hong Kong included) are somewhat reluctant to offer employee stock-ownership plans, more and more businesses realize the value of ESOPs.
You should definitely think about offering appropriate plans of this kind, since more and more professionals consider businesses that don’t offer these plans unattractive.
If you have any questions about this, feel free to contact us.