A beginner’s guide to ESOPs (Employee Stock Option Plans) in Singapore
3 minute read
If you’re a startup in Singapore, you know that you often need additional incentives to draw talent, as the pay that you offer cannot compete with other established players in the market. ESOPs (Employee Stock Option Plans or Employee Stock Ownership Plan) is a tool often used by startups and growing companies in order to compensate the employees in a way that doesn’t put a strain on cash flow in the present.
In this beginner’s guide, we’ll cover what an Employee Stock Ownership Plan is, the benefits of using one in your company, pitfalls to avoid, and things to consider along the way.
What is an ESOP?/ ESOP Meaning
ESOP is also known as Employee Stock Option Plan/Employee Stock Ownership Plan that grants employees the right to purchase company stock. ESOPs are administered by the company’s board of management which lay down the rules of the scheme’s rules.
“An ESOP plan gives an employee the right to purchase shares in a company at a specific pre-determined price on or after specific dates under the plan.
An employee who is granted rights under an ESOP plan by an employer will be taxed on any gains or profits arising from the ESOP plan. Generally, this is when the share options under the plan are exercised by the employee.“ – Inland Revenue Authority of Singapore
Companies set aside an amount of their total equity to offer to key employees over a course of time. The company’s board of management sets the exercise price of the ESOP, but the price set is as close to the fair market value of the shares as possible.
There are two key concepts to an ESOP agreement:
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The ‘vesting period’ – how long it takes for an individual’s share to be drip-fed to them over the course of their employment (typically 3 to 4 years)
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The ‘cliff’ or ‘lock-in’ – the amount of time an employee needs to stay (typically 1 year) before the ESOP ‘kicks in’ and they start to accumulate share options.
The vesting Period Requirement is as follows
|
Where exercise price is |
The Period during which the ESOP may not be exercised |
|
= or > the open market price at the time of grant |
within 1 year from the grant of the option |
|
< the open market price at the time of grant |
within 2 years from the grant of the option |
Credits: IRAS e-Tax Guide
Benefits of ESOPs
There are three key advantages of having an ESOPs scheme in a company that will benefit both the company as well as the employees.
1. It becomes part of the compensation package
When you have limited cash flow, you may have the desire to get the best talent but cannot pay their full market salary. Companies may then supplement their remuneration packages with other things – like share options – to bridge the gap between what they can pay their employee in cash and what the market salary is. ESOP companies can easily attract good talent into their teams especially when the employees themselves see prospect in the company.
2. A drive to build value for the company
When employees feel like they own a part of their company, this sense of ownership in the employees can then have the flow-on effect of aligning their incentives with shareholders – inspiring them to work more efficiently as they see their labor directly contributing to the business valuation.
3. Retaining employees
As ESOPs typically have cliffs and vesting periods, employees under the Employee Stock Ownership Plan may be willing to stay until they are able to exercise their options.
ESOP vs. ESOW
An ESOP is a type of Employee Share Ownership (ESOW).
Employee Share Ownership plans allow an employee of a company to own or buy shares in the company or in its parent company. ESOWs also usually exclude phantom shares and share appreciation rights.
Phantom shares are generally promised to pay a bonus in the form of either cash or equity that is equal to the value of company shares, or the increase in that value, over a stipulated time period.
Contrary to phantom shares, share appreciation rights are only similar to them. However, they also give employees the right to remuneration in the form of the cash equivalent of the increase in the value of a predetermined number of shares, over a stipulated period of time.
ESOP plans (a type of ESOW) give both new and senior employees the right to purchase shares in the company at a predefined price within a specific time period.
Factors to consider when implementing ESOPs
Though there are a lot of advantages to ESOPs, there are also a number of factors to consider.
Setting up the ESOP is complicated
Setting up an ESOP is a flexible but complex procedure with a lot of rules and regulations to be followed in each aspect and many different scenarios to consider. The initial cost of setting up an ESOP is quite high and should involve a lawyer. This is the reason why ESOP companies need the help of a 3rd-party consultant to implement ESOP properly.
What percentage of the company stock to put aside for your ESOP
There is no real hard and fast rule about how big your ESOP should be. However, it is recommended that companies should set a limit on the amount of equity that they wish to share with their employees. For example, a company might set aside between 5-15% of the equity to be offered as Employee Stock Ownership Plans with each employee being given a right to buy equity between 0.5% to 3%.
ESOPs dilute equity shareholding
Along with other activities like fundraising, ESOPs result in ownership being distributed among a lot of individuals, which means that the founder may be left owning only a very small part of his or her company. This can sometimes cause complications when the company ‘exits’ (e.g. is sold or merges with another company).
To avoid a situation where a company’s shareholders from an ESOP are able to block the company’s sale or merger, the company’s board of management should include a clause for drag-along rights that enable a specified majority of shareholders to force minority shareholders to sell their shares on receipt of a third-party offer.
For a great example of how a startup journey might experience dilution through first hires, seed rounds, and Series A, check out Alexander Jarvis’ medium article, “How does startup dilution work for founders, ESOPs, and investment”
What happens when an employee leaves a company after shares have vested
The ESOP agreement should clearly contain a provision as to what happens when an employee who holds an Employee Stock Ownership Plan leaves the company. Generally, an outgoing employee forfeits all his unvested options but retains the vested options until a specified short period of time.
How to structure ESOP?
An individual can structure their company’s ESOP according to the company’s financial health, needs, and objectives. The structure can also depend on the corporate performance of the business.
It would also be good to consider how you should remunerate employees according to market standards, how much you need to value your stock options, and how many stock options you should grant. These issues need to be considered if you are weighing the decision of setting up an ESOP.
In general, an Employee Stock Ownership Plan should have the following criteria.
1. The ESOP Agreement and ESOP committee
A properly-drafted ESOP Agreement structures the ESOP by creating an Employee Stock Option Pool (ESOP Pool) that places a percentage of equity shareholding on the side for employees.
Hence, employees can take part in the company shares through this pool of shares. Moreover, an ESOP Agreement will lay down the details of members of an ESOP committee. The ESOP committee, as the name implies, is a committee made of the company’s directors and other officers.
The ESOP committee has the responsibility to manage the ESOP Pool and recommend suitable actions to the Board of Directors of the company.
2. The Cliff and Vest period
A Cliff or Vest period can be part of the ESOP.
A Vesting schedule indicates that employees will get their shares over time and not all at once. Meanwhile, a vesting ‘cliff’ essentially means that there is a period of time of no vesting, but the benefit will become fully vested when the specified time (the ‘cliff’) is hit.
Most of the time, if an employee who holds ESOP resigns during the ESO Cliff Vesting period, they will not receive any stock options. The Vest period, on the other hand, means the period of time before shares in an ESOP are unconditionally owned by the employee.
Should an employee resign during the Vest period (which usually succeeds the Cliff period), they shall be given prorated stock options based on the length of his or her employment.
3. Selling restriction
A business can include a selling restriction in its ESOP, or a period within which an employee cannot sell their shares.
Tax Implications
Generally, all the gains from ESOPs are taxable as per Singapore law and will be taxed in Singapore if they pertain to Singaporean employees physically present in Singapore. This means that an employee of a company based in Singapore needs to pay tax on any benefit that they derive from these ESOPs. There are tax benefits available for involved parties but it is advisable you contact a lawyer for this.
For advice on how the ESOP affects the company’s position, we recommend speaking to tax professionals. A tax lawyer can give you a good idea on various tax benefits your company or employees can take advantage of.
What’s next?
There are many resources out there to help founders get their heads around ESOPs. Alternatively, you may also wish to speak to a lawyer who may assist you with setting up the ESOP. Contact Sleek if you require recommendations on legal firms that can assist in setting up the ESOP.
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FAQ
Using the Black-Scholes model, ESOP can be calculated by taking into account various factors such as Time Value, Interest Rate, Volatility, Dividend Yield etc.
With ESOP, entitled employees can purchase the shares of their own company at a pre-determined price over a course of time.
