ESOPs Essentials for Beginners (Employee Stock Option Plans) in Singapore
If you're a startup in Singapore, you already know that to attract top talent, you frequently need additional incentives because your payment offering can't compete with other established competitors in the market.
Startups and growing companies often use a tool called ESOPS (Employee Stock Option Plans) to incentivise the employees in a way that doesn’t put a pressure on the existing cash flow.
In this article you'll learn more about ESOP, its benefits, and factors to consider in the process.
- What is an ESOP?
- Why use ESOPs?
- ESOP vs ESOW
- Implementing ESOPs and factors to consider
- ESOP Structuring
- Tax implications
What is an ESOP?
An Employee Stock Option Plan/Employee Stock Ownership Plan, in essence, gives employees the opportunity to acquire shares in their firm. The board of directors administers ESOPs, which are established by the board of management.
Companies allocate 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.
Two essential elements of an ESOP agreement:
- The ‘vesting period' – the length of time it takes for an employee's share to be drip-fed to them during their employment (usually 3 to 4 years)
- The ‘cliff' or ‘lock-in' is the length of time an employee must stay (typically one year) before his or her ESOP 'kicks in,' at which point they may begin to earn share options.
Why use ESOPs? What do you get out of it?
Employees who are familiar with these types of workplace design and procedures will be more productive and have a higher satisfaction level. When you have a tight budget, you will aim to hire the greatest talent but may not be able to afford to pay their market rate.
After that, companies may add extras to their remuneration packages, such as stock options, to bridge the gap between what they can offer their staff in cash against the going market salary.
Motivation to build value for the company
When employees perceive that they have a stake in their firm, they are more likely to work harder because they see their labor directly contributing to the company valuation.
Retaining employees with ESOPs
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.
The difference between ESOP and ESOW
An ESOP is a type of Employee Share Ownership (ESOW).
Employee Share Ownership plans give a worker of a firm the opportunity to have or purchase shares in the business or its parent company. Phantom shares and share appreciation rights are typically excluded by ESOWs. Phantom shares are usually given a premium in the form of cash or equity equal to, or greater than, the value of company shares, on a given time period.
Share appreciation rights are distinct from phantom shares in that they are only similar to them. However, employees may also be entitled to remuneration in the form of the cash equivalent of the increase in the value of a predetermined number of shares over a specific duration. The ESOP (Employee Stock Ownership Plan) is a type of ESOW that gives workers the option to purchase shares at a predetermined price within a certain time frame.
Factors to consider with implementing ESOPs
Even though there are a lot of advantages to ESOPs, there are also a number of factors to consider.
Complications of setting up the ESOP
Setting up an ESOP is a time-consuming and complicated process with numerous regulations to be observed in each area, as well as several alternative situations to consider. Setting up an ESOP has a high initial cost, and it's best to hire a lawyer for the job.
What percentage of equity should contribute to your ESOPs
The size of your ESOP is largely a matter of personal preference. However, it's best to set a limitation on the amount of equity that you want to give workers. A company may reserve 5% to 15% of the equity offered to employees in ESOPs, with each employee receiving a right to purchase stock between 0.5% to 3%.
ESOPs dilute equity shareholding
ESOPs frequently contribute other tasks, such as fundraising, and they result in company ownership being dispersed among a large number of people, suggesting that the owner might only own a small portion of their firm.
If the company's shares become ‘unwanted' in the market, and it is unable to sell them. This can lead to difficulties when the firm "exits" (e.g., is sold or combined with another business).
To avoid a scenario where option holders might block the company's sale or merger, the board of management should include a clause with drag-along rights that allow for a specified proportion of shareholders to force minority investors to sell their shares as soon as they receive a third party offer.
Alexander Jarvis' medium article is a great example of how a startup might go through dilution through initial hires, seed rounds, and Series A. Read more here.
What happens when a worker leaves a company post having their shares vested?
When an employee with an ESOP leaves a firm, there should be a provision in the plan detailing what will happen. An outgoing worker typically forfeits his unvested options but keeps the vested ones for a set length of time.
Structuring an ESOP
The company's financial stability, requirements, and objectives can all be taken into account while structuring an ESOP.
It's also important to think about how you should recompense staff in line with market norms, the amount you'll have to value your stock options, and how many stock options you'll need. If you're considering establishing an ESOP, these factors must be taken into account.
In general, an ESOP should meet the following criteria.
1. The ESOP Agreement and ESOP committee
An ESOP Agreement is a legal document that outlines the responsibilities of both employees and management in regard to the Employee Stock Ownership Plan. It organises the ESOP by establishing an Employee Stock Option Pool (ESOP Pool), which gives a percentage of equity shares to workers.
Employees can utilize this pool of shares to participate in the company's stock options. Furthermore, an ESOP Agreement will provide further information on the members of an ESOP committee. The ESOP committee, which is named after this term, is a group composed of the company's directors and other officials.
The ESOP committee is in charge of the ESOP Pool and must make suggestions to the Board of Directors of a business on how to use it.
2. Periods for The Cliff and Vest
A vesting period, also referred to as a cliff period, may be included in an ESOP.
Employees will receive their stock over time rather than all at once, as shown by a vesting schedule. In contrast, a vesting cliff effectively means that there is a period of time when the benefit isn't vested, but it will be fully vested after the designated length (the ‘cliff').
If a member of an ESOP who has resigned during the Cliff period does not receive any stock options after leaving, it is because they will are not entitled to any. The Vest period, on the other hand, refers to the time before shares in an ESOP are owned unconditionally by its workers.
If an employee quits during the Vest period (which usually follows the Cliff period), they are entitled to compensation in line with the length of their employment with a pro-rated stock option grant.
3. Selling rules
A selling restriction may be included in an ESOP, or a time period during which employees are unable to sell their stock.
All profits from an ESOP are taxed in accordance with Singapore law and are taxed if they come from Singaporeans working in Singapore. This implies that a Singaporean citizen employed by a firm located there would be required to pay income tax on any profit earned from these ESOPs. We recommend consulting with tax experts for assistance on how the ESOP affects the firm's position.
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