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What is ESOP and how does it work?

Employee Share Ownership Plans (ESOP) are mechanisms devised for companies with the aim of offering their employees the right to buy company shares. They can also be a specific percentage of shares.

These employee-owned shares come at a fixed price, also known as the exercise price, and are valid during a specified period called the exercise period during which the workers hold ownership of the shares.

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.

Overview:

Why Are ESOPs Popular?

As mentioned above, the exercise period allows 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. Stock ownership is not mandatory and nobody is required to buy shares or join the employee owner program. On top of that, there is no universal rule on how large the option pool should be. A company determines that.

So what does this bring to employees interested in exercising the right to become stock owners?

From an employee’s perspective, they can make a profit equivalent to the difference between the future valuation of the company and the exercise price of the stock.

Companies see this as a useful method to reward key employees to stay in the company, without monetary compensation, by granting them equity interest to share in any future growth in profits that they receive rights to when they buy stock.

ESOP, to some, is an alternative method to incentivize and motivate key performers and talent. In simpler terms, private companies choose to make employees share owners through employee stock options rather than provide employees with higher salaries or other forms of monetary remuneration and capital gains.

ESOP is, thus, quite popular with startups and early-stage businesses that have certain limits when it comes to financial resources and don’t have a lot of capital yet. Becoming stock owners can be more attractive than a cash reward to some workers, especially in private companies.

Finally, ESOP 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 owners enough time to determine if they wish to commit to each other for a longer period of time.

Who Can Benefit From ESOPs?

An Employee Stock Ownership Plan (ESOP) does not necessarily apply to employees only. It can also be granted to:

  • Directors
  • Officers
  • Consultants

If there is obvious potential in the company, these individuals can take advantage of the option too and become share owners. It’s not just regular employees who can purchase shares.

Benefits of ESOPs

We will examine the benefits of an Employee Ownership Plan (ESOP) 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 scheme in both cash and company stock.

These benefits are allocated to the individual accounts of participating employees in the trust created as part of the ESOP. The accumulated balance in a participant’s account is then distributed to the participants following their retirement or end of employment.

Keep in mind that the value of the ESOP benefits account is not taxable to the employee owners 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

An ESOP 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 (i.e. you don’t have to pay tax on them), 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 as well 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. In essence, the tax benefits are more than obvious for both the companies and employees.

FAQs

Let’s go through some frequently asked questions and common uncertainties people have regarding the Employee Stock Ownership Plan (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 (ESOP) 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 the Employee Stock Ownership Plan (ESOP). 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 employees who choose this option are required to report such an amount to the Inland Revenue Department (IRD) for tax calculation purposes.

Luckily, the way ESOP works allows it to not be seen as a relevant income for Mandatory Provident Fund (MPF) purposes. But 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 Employee Stock Ownership Plan (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 ESOPs. 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.

When should I set up an ESOP?

Usually, corporations turn into Employee Stock Ownership Plan (ESOP) companies when the founders come to the conclusion that they should hire senior level employees.

When a company sets up an ESOP and decides to offer stock, they usually do so when they’re trying to attract senior employees that are willing to receive a lower wage in exchange for employee owned company shares. In other words, these new employees would accept less monetary sum for the chance of getting equity in the company by purchasing the company’s stock.

We also need to talk about granting share options to your key employees. They will want to receive them as soon as possible, especially in the early stages of the company.

The exercise price for your company’s share options will be set based on the market value shares have when the share options are being granted. If you grant share options at the company’s early stages, you will pay a low fair market value, which increases the chances of the key employee making a profit.

What are some administration duties and other considerations?

Establishing an Employee Stock Ownership Plan (ESOP) comes with a relatively low upfront cost and it’s a fairly easy process for company owners. Before the process can be approved by the company director, it needs to be adopted at the company’s shareholders’ levels, which is done during the AGM.

When the plan is adopted, the company is required by law to issue something that is known as an “Option Certificate”. This certificate sets out all of the ESOP’s terms and conditions. You can also issue an explanation note that explains the procedures that need to be followed.

This is done for the exercise of the option by the employee, and if that situation does occur, the share capital of the company will be increased and newly issued shares will be allotted to the new participant. It’s essential to keep records of these transactions and comply with all statutory filings with the Companies Registry.

Companies often wonder if they should grant these options at the subsidiary level or at the group/holding level. And since the value is typically located in the holding company, it makes more sense from a business perspective to grant them at the group level.

Just keep in mind that employees who receive allocated shares will acquire some controlling power in both the holding company and all its subsidiaries, however indirectly, due to partial ownership. This means that the employee who chooses to buy shares will also hold voting rights.

Wrap Up

The Employee Stock Ownership Plan (ESOP), 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 corporations realize the value of becoming ESOP companies and are happy to let employees pay for stock options.

You should definitely think about offering appropriate plans of this kind since more and more professionals consider businesses and corporations that don’t offer such plans unattractive.

Thinking of registering your business in Hong Kong? Sleek can help you get started. If you have any questions about this or ESOPs, feel free to talk to our sales team.

Start a business in less than 3 hours with us. Talk to our experts today.

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