ESOP

Employee Stock Ownership Plans – What, how and why?

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July 1, 2022

Employee Stock Ownership Plans – What, how and why?

The recipe to beat your competition with a kick-ass team: Well-crafted Employee Stock Ownership plans (ESOP). They can be extremely powerful, and at the same time very cost-saving.

One of the most important jobs of any CEO is to recruit and retain top talent. With the current talent war out there, this is harder than ever. This is where Employee Stock Ownership Plans (ESOP) can have a very powerful effect.

If the ESOP term is new to you, let´s start with the definition of the term by Investopedia:

“An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company”.  

This is often also referred to as incentive plans, ownership plans or equity plans. As employees can be incentivized by different types of equity, which we will cover more below.

Implementing an ESOP program is probably the most effectful decision a company can make to ensure long term motivation of their team. Many companies, especially startups and growth companies also use ESOP actively as part of the compensation package to save money with salaries below market standard.

A Highly Motivated Team

Owning a part of the company has a very motivational effect to most people. In fact, it can be so powerful that in many cases it gives people a “purpose”. They get the feeling that they are building something for themselves.

Co-ownership also creates a solid team culture, or an “us” culture. It makes people more tolerant to hard work and tough times many early-stage companies may have to push through.  

This makes people less opportunistic during these tough times, where employees with no ownership may be more prone to start looking for alternatives.

Saving Cost with Reduced Salaries

Most companies that actively use ESOP as a tool, use this as a part of the overall compensation package. For most companies, this have a strong effect on the financials as salaries are usually the biggest cost.  

By awarding equity to employees, salaries can be reduced below market standards, saving the company precious capital. This is often a must do in early-stage companies.

This is something early-stage investors find favorable and even expected. Both because it is good for the financials of the company, but also that the team has skin in the game and are proving commitment and belief in the company by swapping secure bucks for a potential upside.

Different Types of Equity and Plans

Employee Stock Ownership Plans can take many forms with different types of equity. First a definition of equity as provided by Investopedia:

“Equity represents the value that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company's debts were paid off.”

In short, this essentially mean what you would be paid when selling your shares.

The most common equity types are Restricted Stock Awards (RSA) or Stock Options, often just referred to as stocks and options. But there are also other types which can be considered, such as Restricted Stock Units of Phantom Stock plans.

The main difference between stocks and stock options, is that stocks are actual/current ownership in the company with the related benefits and stock options are right to purchase stocks in the future at a predetermined price.  

We will cover these different equity types in more details in separate blog posts in the future, as this blog post is aimed at providing a better holistic understanding of Employee Stock Ownership Plans in general.

The fact that a company must decide which equity and ESOP structure to go for makes this a complex decision as there are different considerations to think off, such as cost, tax implications, motivational effect, legal consideration, practicality etc.

There are many factors to consider when choosing equity types and plan structures. In our consideration, the best structured plans have max motivational and retaining effect, while minimizing cost and tax burdens to the plan receivers.  

Tax and cost considerations

The stage of the company at the time the plan is implemented is often the driving factor when choosing equity type. The reason is the implication on the cost to participate in the plan and the corresponding tax implications. In other words, the short- and long-term financial effect of the plan for the plan receiver.

From a tax perspective, any financial benefits tied to the employment in a company are in most jurisdictions considered taxable as income tax. While gains on investment are taxable as capital gain. This matters as income tax are often significantly higher than capital gain tax.

However, in many locations there are special considerations in the tax regime, allowing more room for what companies can do when implementing ESOP for their team and minimizing the tax impact. This is often tailored for early-stage companies. The idea behind this is to foster new businesses and economic growth. Which speaks to the powerful effect ESOP may have. So be sure to check any local tax exceptions before structuring ESOP for your team.

Equity types such as Stock Options, Restricted Stock Units (RSU) and Phantom Shares are all structures which by default mainly fall in under income tax regimes. This is because the employees then receive a benefit as a result of their employment. The exception to this common rule is any potential tax exemptions as mentioned above, this is more common for stock options.  

Having covered tax implications, we would like to add that companies should strive to minimize the tax impact to the plan receivers to the best of their abilities. In cases where a company cannot use any special tax exceptions, the best way to do so is to structure the plan so that any financial reward is considered as capital gain.

To put it simple, this often means direct ownership through Stock (shares). We refer to this ESOP type as Restricted Stock Awards. This is essentially means granting stocks with certain restrictions, more on this in the section with terms and conditions.  

 

Now that we have addressed Options and RSA, let´s us give you a couple of examples on why timing matters when choosing which structure to use. Say, you want to offer employees an ESOP for the below scenarios:

Scenario 1: Company has a high (Fair Market) valuation

The employees either have to:

  1. Pay the fair market price for the shares. In many cases, they cannot afford it and they are taking a higher risk and it is not considered a compensation. And any gain will be taxed as capital gain.
  1. Pay a discounted price for the shares. This will immediately trigger an income tax requirement for the price difference at time of accepting the grant. In many cases, they cannot afford it and they are taking a risk. Any additional gains will be taxed as capital gain.
  1. They can accept an option plan. This will not trigger an initial tax requirement, but they will have to pay to exercise the options later (convert to shares). They are not taking an initial risk. But there are some limitations to options. And any gains at exercise will be taxed as income tax. Maybe before the shares can be sold to free up money to pay the taxes. Unless any local exceptions apply.

Scenario 2: Company has a low (Fair Market) valuation

This is often before the company has issued equity to any outside investors. This case is so much easier compared to the other scenario. Now employees can buy shares at a very low price. Then a RSA plan is the best option. This is now both affordable and beneficial from a tax perspective as any gains are taxed as capital gain.  

Note: There are ways to make the RSA structure practically feasible even after taking outside investments. We will cover more one this in a separate blog post later.

Terms and Conditions

Another factor which makes structuring ESOP complex are the many difficult terms often used in relation to the agreements.

These terms are mainly put in place to give the desired motivational effect to the plan receiver or to protect the company for undesired scenarios. This is a mitigating measure for companies to avoid ending up with a broken and non-fundable cap table. Meaning a lot of the ownership is left with people not working in the company.  

One of the most common terms is (reverse vesting and) vesting. This determines how the employees earn the right to keep shares, exercise options or settle RSU´s. This can either be 1) time-based, how long an employee need to work in the company, or 2) condition based, often based on performance or company liquidation or 3) a combination of these. Shares or options are often partially vested at certain thresholds. And often a Cliff period is also included, meaning an initial period the employee must work with the company to keep any rights.  

Other typical things a plan often include is post-termination clauses for certain scenarios, plan expiration date, lock up periods, rights of first refusal etc. Some of these things may also be addressed in a Shareholders Agreement (SHA), specifically for working shareholders.

Other things to be aware of is share classes. A company can have certain share classes on their issued stock. This can affect voting rights, dividends, and payout preferences.  

In short, ESOP structures has an element of risk to both the employee, but also the company. A well-crafted ESOP structure and agreement can mitigate this risk for both parties. We will cover more about this and terms and conditions in general in separate blog post later.  

Communication, Consistency & Fairness

As with all things in business, communication is important, but often not taken serious enough. When plans are crafted, many different stakeholders may be involved. Founders, different types of investors, board, existing employees, new employees etc.

Good communication all the way from the beginning and through the process is important. This helps to structure a fair plan and a motivational plan that works for many, a plan which are bigger chance of being approved or accepted, plus it is helpful to reduce friction and disappointment.

We have seen many managers overpromise on plans but fail to deliver on implementing an ESOP program. This is a complex domain and many important factors to consider, which often leads to managers postponing the decisions. It may be postponed to the point where the desired plan structure is not feasible. This often leads to frustration among the team and may lead to employees leaving the company.  

Communication through the plan period is also helpful to keep employees motivated and makes them feel included.  

We also recommend that the team, especially key resources always have an active plan. Meaning a new ESOP structure should be offered to them before the existing plan expires. This is a good proactive to retain talent and keep motivating the team in the long run.  

ESOP Pool Size & Grant Size  

A question we often get is how much equity should be allocated to ESOP programs. This is not exact science, and it depends on company ambitions, need for people and timeline. However, somewhere between 10-20% is often consider normal. This is in addition to the founding team which sits with all or most of the equity before taking any outside investments.  

It is also very common that ESOP pool size is being topped up at every investment round, which is often followed by a need to hire people. This is usually the point in time when a need for different type of ESOP structures become necessary.

And how much equity to give to each person is also something which should be considered carefully. First, we need to try to look into the future of the business and try to forecast employee needs and make a plan that works in the long run. It should also be fair. If you mess up the contribution, you may end up with dissatisfied employees. It is ok that employees starting earlier gets a higher pot then employees that comes onboard later. And it is ok that senior employees in higher positions receive a higher pot then more junior people. But the general principle should be fairness. Consider it as part of the compensation package. If one is taking a higher pay cut than another, you may compensate with equity. Again, this is often tied to seniority or the role.

Although the common name is Employee Stock Ownership Plans, it is not limited to employees. It is not uncommon to also compensate Board of Directors or advisors with equity. This is especially powerful in the early days of a business, when cash is scarce, when you have little to show for, a small team and hence the need for solid contributors are higher. Some different rules may apply; however this is more often related to special tax exceptions for stock options.

Having outside contributors (other than employees), which are compensated with equity, are often referred to as “sweat for equity”. This is a good practice to get assistance to get off the ground. But be mindful of how much equity you give away at this point in time, you still need to plan for the long run and appreciate the equity you have. Too many give away too much equity at start, which may come back to haunt them later. We will cover more about this in a separate blog post.

Other Factors

There are many other factors which we have not covered in this blog post, which we will cover in more details in other post. These include, but are not limited to:

Source of the shares (newly issued, treasury, secondaries), Investors’ expectations and often requirements. Setting up a new equity pool pre- or post- money valuation when raising capital and the related dilution effect. Accelerated vesting. Employees consideration of using a holding company. Accounting and reporting requirements. Tax requirements etc.

ESOP Software & Advice

The domain is complex and requires administration both when implementing a program and throughout the program. A software to administrate this will save both precious time and money, allow you to be in complete control and compliance while keeping the employees updated and motivated.

Our software will initially help you implement all plans, guide you through the process by use of wizards and send the ESOP plans for electronic signatures. The documents will be stored in a separate documents center ensuring full traceability, easy access, full control, and compliance. This is not only important for business owners to protect the business, but also a must have when raising capital.

The software is structured in a way that allows you to reduce admin burden (when issuing new plans and exercising options. Meaning less need to gather the entire general assembly every time you want to issue new equity. This is handled through a pre-approved pool structure, and you can set up program templates easy to implement to new employees.

The company manager (admin user) has a nice dashboard overview of all ESOP in the company and can manage them from one place. Both adding new ones, editing old ones, update stakeholders, exercise stock options etc.  

Likewise, the plan holders get their own dashboard with all information, such as plan details, development, vesting schedules etc. This is designed in such a way to keep employees informed and motivated as they see their values increase over time.

You will also get a full cap table overview with the list of all stakeholders for easy stakeholder management. This is allowing for different views to illustrate cap table composition.

The notification center will make sure to keep everyone updated, inform them about changes, nudge them to take necessary actions and send reminders when needed. This will reduce both risk and admin burden around the required follow up on these plans.

For example, when an employee wants to exercise stock options, they will send a request, which the manager must approve, before they can wire money and the manager again will issue the shares. This is handled seamlessly through the software and significantly reduce admin burden.

The other side of this is the accounting and reporting requirements. Stock Options needs to be expensed and there are tax requirements for employees and in some cases the companies. Having a system that can report and forecast the required numbers are timesaving and keeps you in control.  

Conclusion

When building high performing team and culture there is nothing more powerful then to implement Employee Stock Ownership Programs. The beauty about this, it will also help reduce cash burn. Two things which are very important in both the early stage and the growth stage of a company.  

However, this is also a complex domain, both from a legal, tax, cost and practical perspective. There are many things to think of. Doing things the right way from the beginning is very important. There are some best practices and there are common pitfalls that you must be mindful off.  

Trying to figure out everything yourself will demand a lot of time and there is a high risk of making mistakes which may come back to haunt you. Using accountants and lawyers for this may often seem the only way out. This is often also very expensive, and they might give you secure legal advice, but may not always be the best from a business or venture building perspective.  

We advise companies to analyze their company phase and needs and make the right plan and the right time. Both from a cost, tax and motivational perspectives. This changes as the company develops. And it is also important to try to plan this in the long run.  

Both implementing and administration can be dauting and time consuming. There are great benefits to consults with experts in the field in the implementation process and use a software which can save you valuable time and cost and keep you in full control.

You are very welcome to book a free call with one of our experts to learn more about this.  

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