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) 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 ESOP is, the benefits of using one in your company, pitfalls to avoid, and things to consider along the way.
- What is an ESOP?
- Why use ESOPs?
- ESOP vs. ESOW
- Factors to consider with implementing ESOPs
- How to structure ESOP?
- Tax implications
What is an ESOP?
In essence, an Employee Stock Option Plan/Employee Stock Ownership Plan grants employees the right to purchase shares of their company. ESOPs are administered by the company’s board of management who also lay down the rules of the scheme.
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:
- 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)
- 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.
Why use ESOPs?
ESOPs have a lot of advantages for the companies as well as for the employees.
Can be used as part of compensation package
When you have limited cash flow, you may have a 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.
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.
As ESOPs typically have cliffs and vesting periods, employees under the ESOP 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 in 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 employees the right to purchase shares in the company at a predefined price within a specific time period.
Factors to consider with 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.
What percentage of equity 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 the employees. For example, a company might set aside between 5-15% of the equity to be offered as ESOPs 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 option holders 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 ESOP 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.
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 ESOP 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 Cliff 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 pro-rated 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.
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.
For advice on how the ESOP affects the company’s position, we recommend speaking to tax professionals.
So now what?
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. You may contact us if you require some recommendations on legal firms that may assist you in setting up the ESOP.