BUSINESS ARTICLE

The Ultimate Guide to an Employee Stock Option Plan (ESOP)

The Ultimate Guide to an Employee Stock Option Plan (ESOP)

The Ultimate Guide to an Employee Stock Option Plan (ESOP)

Introduction to Employee Stock Option Plan (ESOP)

We have all heard of an employee stock option plan / employee stock ownership plan or ESOP in abbreviation, but how does an ESOP scheme work in practice, and how do you determine if it’s suitable for your company? In this article, we will provide the basic guidelines of an ESOP plan and how it works so you can see if it might be a viable solution for your business.

What is an Employee Stock Option Plan (ESOP)?

An employee stock option plan or ESOP for short, is one form of remuneration given to employees, by means of retaining them or to reward them based on their performance. They are usually offered in the form of company shares which gives the employee ownership rights as a shareholder of the company. As part of an ESOP scheme the employee is able to acquire the shares at a predetermines price, or what we call an exercise price.

The Lifecycle of an ESOP scheme

The lifecycle on an ESOP scheme can be broken down into a few events; Offer, Vesting, Exercise, Leaver and Lapse. An employee will firstly accept an ESOP option offering, whereby a fixed number of options will be allotted to them. After a certain timeframe, a proportion of the allotted options will vest, which means that these options can now be exercised.

To exercise these vested options, the employee will pay the total exercise cost (number of options x exercise price) and receive actual shares of the company thereafter. If they don’t exercise these vested options after the expiry date, these vested options will lapse or expire, meaning the participant can no longer exercise these options moving forward. If the employee leaves the company halfway through the ESOP’s lifecycle, in some cases, all their vested and unvested options will lapse completely. This will depend on the particular company’s employee stock option plan rules.

Why would companies adopt an Employee Stock Option Plan (ESOP)?

Companies who want to grow their business whilst mitigating costs will usually adopt an ESOP plan. The this is driven by two primary reasons:

  • Employee performance is directly linked to company performance and thus employee remuneration. Employees can only benefit from their ESOP when the market price of the company is above the exercise price which means that a company needs to grow in order to spur the market price of the share.
  • There is no heavy upfront cost to the company. Cost to the company in this case is only incurred during the exercise of option. Furthermore, the exercise cost will be covered by the employee so it’s a win win for companies looking to grow whilst mitigating costs.

How do employees benefit from an ESOP?

When employees are rewarded with shares of the company, they essentially become part owners in the company. This in turn has a direct correlation with employee performance and investment in business performance. The employee’s actions, decisions and work output are all focussed on the greater good of the firm as this is mutually aligned with their own rewards.

Employee Stock Option Plan (ESOP) Illustration

To provide an illustration, say on 1st Sept 2019, Mei San has accepted her company’s ESOP 2019 Offer for 900 options with an exercise price of S$ 1 per share. These options will vest annually across 3 years in equal proportions. The expiry date of the options will be 10 years from the offer date, which will be 1st Sept 2029.

ESOP 2019 OfferVesting DatesOptions to be vestedUnvested OptionsVested Options
Allotment Day1st Sept 201909000
Vesting 11st Sept 2020300600300
Vesting 21st Sept 2021300300600
Vesting 31st Sept 20223000900

A few points to take note of in the table above:

  • On 1st Sept 2019, 900 options are allotted but remain unvested, which means Mei San cannot exercise these options
  • On 1st Sept 2020, 300 have vested meaning Mei San can exercise them by paying the exercise cost of S$ 300 (300 Options x S$ 1) to acquire 300 shares of the company
  • After 1st Sept 2029, all vested options will lapse, if Mei San has not exercised them prior to this date she will not be able to do so, they have effectively expired
  • If Mei San leaves the company to join another firm halfway through, all vested and unvested options shall expire upon notice of resignation

Other variables to consider:

The illustration above is only one of many examples. Common variables that change include:

  • Inclusion of a performance matrix, where the number of options to be vested will depend on the employee’s work performance
  • More frequent vesting (e.g. Bi-annual), to entice employees with “more” reward
  • Broad-based share option plan where all employees are offered the options plan to encourage ownership thinking across the company
  • Some companies may allow retirees to continue to hold on to their vested options until the expiry date

Depending on your company’s requirements, you will need to understand the implications of these variables, and whether they can help achieve your ultimate objective of your employee stock option plan (ESOP).

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