An employee share option scheme (ESOS) is a means of offering key employees or consultants the opportunity to acquire shares in the company.
Advantages of an Employee Share Option Scheme
For startups, it allows the company a means of compensating its employees, aligning the employee’s incentives with those of the company, and allowing them to participate in the growth of the company’s equity. An important consideration for startups is that it conserves cash and allows the company to reduce its burn rate.
For mature companies such as multi-nationals, an ESOS is still desirable in that it aligns the incentives and long-term interests of the employee with those of the company by allowing the employee to become a part owner of the company.
How an Employee Share Option Scheme works
Most ESOS work in the following manner. An employee is selected to participate in the ESOS and awarded a certain number of unvested stock options. The vesting schedule for such stock options then follows a pre-determined chronology or certain financial or growth milestones for the company. For example, 50 percent of the options may vest after the employee has worked for 2 years, with an increasing percentage of options vesting the longer the employee works for the company.
Options which have vested may then be exercised by the employee for shares in the company. The exercise price is usually at a discount to the fair market value of the company’s share price to allow the employee to enjoy a certain premium.
Such shares which are awarded to ESOS employees may be new shares issued by the company, treasury shares which have been set aside for the purpose of the ESOS or existing shares transferred from majority shareholders. In general, the “compliance-lite” route for a startup or small company would be to issue new shares.
A company which has implemented an ESOS will have a set of ESOS rules. This is a comprehensive legal document which governs various parameters of the ESOS. For example, who decides on the awardees of the ESOS, how the exercise price of options is determined, and what happens should an ESOS participant decide to leave the company, whether under happy or acrimonious circumstances.
An ESOS takes some effort to set up, but once established, provides the company with an additional means of compensating key employees and aligning their interests with those of the company.
Frequently Asked Questions
Question 1: Should a company limit the number of employee share options that it issues?
Whilst issuing employee share options may seem like a good way of conserving cash, companies need to set a clear limit on the number of options they will be issuing. A company which has issued a large number of options may be less attractive to investors as the company’s equity could potentially be further diluted in the future when the share options are exercised.
Question 2: Which provisions should companies pay special attention to?
Companies need to pay special attention to the “bad leaver” provisions in the ESOS rules. These are the provisions that determine what happens to an employee’s options and ESOS shares when an employee leaves the company under acrimonious circumstances. It would be undesirable for a former employee to still hold options or ESOS shares if the former employee has a potential dispute with the company.
Question 3: Which concepts usually require clarification?
We frequently need to clarify the difference between unvested options, vested options and ESOS shares. Unvested options are what an employee initially holds when the options are first issued. Such options cannot be exercised for shares. Unvested options then become vested options following a certain vesting schedule. The employee may then (but is not obliged to) exercise vested options for ESOS shares in the company by paying the exercise price for each option. After successfully exercising their vested options, the employee would hold ESOS shares and have substantially the same rights and responsibilities as other shareholders.
Question 4: Which provisions should employees pay special attention to?
Employees need to take a close look at the vesting schedule to determine if it makes sense for them to accept ESOS options. This is especially so if options are being offered in lieu of salary. An unduly long vesting schedule means that compensation in the form of ESOS shares is delayed to a few years down the road. Employees should also assess the overall prospects of the company and reach their own conclusion as to how well the company is likely to do. It may not make sense to accept ESOS options if the company is likely to fold in the near future!
Employees should also take a close look at the exercise price for their options. How the exercise price is set would determine the premium (if any) that they would enjoy between the exercise price and the market price of the ESOS shares.
Finally, employees should take note of what happens to their options and ESOS shares in the event of an “exit event”, for example, if the company goes through an IPO or is sold to a third-party investor. Employees should be aware as to how and whether their options and ESOS shares allow them to participate in the potential upside from such an “exit event”.
Need advice on Employee Share Option Schemes?
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This article does not constitute legal advice or a legal opinion on any matter discussed and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and practice in this area. If you require any advice or information, please speak to a practicing lawyer in your jurisdiction. No individual who is a member, partner, shareholder or consultant of, in or to any constituent part of Interstellar Group Pte. Ltd. accepts or assumes responsibility, or has any liability, to any person in respect of this article.