ESOP! Employee Stock Option Plans

For fun, let’s start with a wee bit of confusion.  “ESOP” can refer to an “Employee Stock Option Plan”, which is a plan which allows employees to receive and exercise options for the purchase of company shares.  In the US, however, and as the SEC points out, “ESOP” refers to an “Employee Stock Ownership Plan”, which is a type of retirement plan in which employees save for retirement by investing in the company they work for.   So, to set everything straight, I’m using the term ESOP in this post (and elsewhere in this website) to refer to Employee Stock Option Plans, even when those plans might be in the US.  If you do additional research on your own (always a good idea) and you start seeing terms like “ERISA” or “defined contribution” or “pension”, run away!

Up until this point, I’ve focused on “vanilla” options.  But there are many types of equity-based compensation (that is payments made either in the form of company equity or based on company equity) and a single ESOP may be used to issue several of these.  For example, an ESOP might allow for issuance of options, shares, restricted shares and restricted share units.  I’ve added those last two to my never-ending “things to write about” list. In the meantime,  Motley Fool has a lovely, user-friendly piece on the topic.

We’ve already talked about what options are and how options work in previous posts.  An ESOP is simply a framework under which options and other forms of equity-based compensation are granted.

The plan will spell out how, to whom and under what terms equity-based compensation  may be granted. The plan will also include any rules applying to the options, shares or other instruments issued under the ESOP.

To give you a better idea, here are some key topics you would generally expect to see covered in the ESOP plan document:

  • how company shares are to be allocated to the ESOP (that is, be made available to issue as awards)
  • how and by whom the ESOP is to be administered;
  • what types of equity-based compensation may be issued;
  • who is eligible to receive awards (e.g. employees, employees of the company and its subsidiaries or just of the parent, employees and suppliers, etc.);
  • how award terms are to be set and the process by which awards are to be approved;
  • any limits on transferability of the awarded shares or options;
  • limitations on the recipients rights as shareholders (e.g. being required to sign a proxy);
  • conditions under which an award will terminate (e.g. an employee leaves the company);
  • what happens to awards if there is an exit event (e.g. an IPO or someone buys the company);

…and more along those lines.

In addition to all of the above, the Plan will need to address taxes.   One of the potential pitfalls of an ESOP is that employees are receiving something of value as payment for services. Technically, this should be subject to tax, just as their salaries are. The problem is that this creates the very real risk that employees will end up paying taxes on a benefit that they ultimately don’t benefit from.   This risk is particularly acute when the options are in startups, which have a high rate of failure.

To offset this risk, tax authorities in various countries have enacted laws which allow companies to issue employees options while delaying any tax payments until some later event, such as when they sell the resulting shares and have (hopefully) earned some  money.

These laws vary from country to country and a country and a country might have more than one option available.  For example, a country might offer two tracks, one for large companies and one for small. In addition, companies must meet certain requirements in order for a plan and/or a grant made under the plan to be considered “tax-advantaged”.  For example, in the US, these requirements include that (1) the exercise price be at least equal to the fair market value of the share as of the date of grant and (2) the company perform a valuation in order to determine what that fair market value is.

As such, when setting up the ESOP, the company will also need to decide what tax scheme they will be using for each country in which they operate.  Country-specific appendices can then be added to the document, with each appendix including the terms applicable to grants issued in that country.  As a result, it’s possible for employees in Country A to receive different terms than those in Country B.

How to Establish an ESOP
Have your legal counsel do it and make sure that your counsel is sufficiently familiar with ESOPs. Seriously.  If you do this one wrong, it’s liable to cost you and/or your employees a lot of money, so it’s worth doing it right.  For Israeli plans, seeing how you will need to have a trustee in any event, consider consulting with the trustee as part of the set-up process.

Conversation can be key here.  For example, if you are planning on opening up a subsidiary in the US in a year and  transferring some of your key employees there, let your counsel know.  These types of events have tax ramifications, but with some advance knowledge, your counsel will be better able to determine an appropriate plan structure and  also to give you instructions on how to manage the grant process on your end.