Employee Stock Option Plan (ESOP) – What Are They & How Do They Work

Hiring top talent is one thing, retaining them is another.

Companies in Singapore find it challenging to retain top talents for a significant period. So, in their attempt to ensure the top talents stay with the organization, companies introduce a host of offerings that benefit the employees and improve their chances of staying back.

One such financial instrument commonly used by startups and other companies is ESOPs or employee stock option plans. However, these options come with their share of difficulties and can often be cumbersome because of their tax implications and lock-in restrictions.

This guide discusses everything you need to know about ESOPs, including their mechanism and pros and cons.

What are employee stock option plans for private companies?

When someone acquires equity ownership of a company, they become part owners of the company. ESOPs are equity compensation that organizations grant to their top-level employees and executives. The company is of the opinion that such employees are an integral part of their success, hence, offer them part ownership of the company.

But instead of offering direct equity, they provide derivative options on the stocks instead. These are known as employee stock option plans (ESOPs). ACRA allows companies in Singapore to set aside a part of their equity to offer to valuable employees over a period of time. The board of management is responsible for administering and laying down the rules of the scheme.

An ESOP is not an actual equity share of the company but is a contract that entitles the eligible employees to subscribe to a certain number of shares at a strike price. That said, you cannot buy the equity immediately, and there is a vesting period involved that determines when and how many shares you can subscribe to.

Concepts related to ESOP

ESOPs can be pretty challenging for a layman to deduce. So we thought of first, running you through the key terms associated with it before explaining the process –

Exercise

It is the act of an application submitted by the employee to the company that states his acceptance of ESOPs after the vesting period and as specified.

Exercise period

Once the vesting period ends, the organization allows the employees a window for subscribing to the options. Such a timeline is called an exercise period. Any options not exercised by the employee during this window will stand lapse, and they cannot subscribe to them after that.

Exercise price

The exercise price is the most vital part of the ESOP deal. Usually, stock options ensure employees get the shares at a much lower price than the current market value. It makes the possibilities a lucrative offer for the workforce. The price at which employees can exercise their ESOPs is known as the exercise price or strike price.

Grantee

The employee eligible to receive ESOPs is known as the grantee.

Grantor

The employer who offers ESOPs to their employees is known as the grantor.

Grant

Grant refers to a formal letter or communication issued by the organization for granting ESOPs to an employee.

Grant date

The grant date is the date of the agreement between the employer and employee to give the latter an option to buy organization shares.

Vesting

We consider ESOPs to be vested when the grantor allows the grantee to exercise their options and acquire the company’s stocks. The employee must be careful while determining if they want to be vested and go through the rights available and restrictions attached with these options.  

Vesting period

The vesting period refers to the time that the employee must wait if they want to exercise their ESOPs.

Reload option

Many companies offer additional ESOPs to  employees who exercise the ongoing options program. Such an offer is termed a reload option.

European-style options

European style options refer to contracts that are exercisable only during a specific period. It means that the employee cannot request for early delivery of the instrument.

American-style options

American-style options allow employees to execute the contract anytime between the grant date and expiry date.

Intrinsic value

Intrinsic value refers to the difference between the stock price (current market price) and the strike price (the price which employees have to pay). If the difference is negative (i.e., the strike price is higher than the current market price), the intrinsic value is 0.

Re-pricing

There can be times when the existing strike price for the ESOPs has gone out of the money, and the difference is significant. In such a case, the grantor re-prices the contract at a lower strike price for the grantee.

Expiration date

The expiration date is the last date by which an employee must exercise their options.

Why are ESOPs issued?

To improve retention of key employees.

Companies, especially startups, suffer from a high churn rate. So it is imperative for them to look for ways to retain vital talents for a longer span. ESOPs are one of the best ways to do so. Here, the organization offers a piece of equity ownership to employees but with certain restrictions.

More often than not, employees find exercising the options more lucrative as they stand to benefit directly from the company’s growth. It also motivates them to perform better at their job and improves commitment as they now see long term benefits.

How do they work?

The company’s Board of Management is responsible for administering the ESOP process and laying down rules. The company’s financial needs, health, and objectives are the key factors in determining the final structure of these options.

Here is how they work –

Drafting the rules

ESOPs are employee benefit options that require companies to look into several factors for successful execution. So the grantor starts by setting the rules applicable to the current employee stock options. 

It includes the granting process, the number of eligible employees for exercising, the process, and what happens if the employee doesn’t exercise the option or leaves the company during the vesting period.

Since ESOPs require companies to set aside a part of their equity for distribution to their shareholders, the process requires special care in the drafting stage. 

An efficiently drafted ESOP agreement enables the organization to develop an ESOP pool that gradually helps in an increased emphasis on valuable employees and placing an equity shareholding percentage for each of them. 

It also sets the terms for establishing an ESOP committee, comprising the director and other relevant officers, for recommending a plan of action to the Board of Directors. They are responsible for the smooth carrying out of ESOP granting and efficiently managing the ESOP pool.

Board and shareholder approval

Once the rules for ESOPs are drafted, the next step is to prepare a set of directors’ resolutions to be approved and signed by the company directors. Another similar set is prepared for shareholders’ resolution and is presented to them in a meeting for their approval.

It contains the following details –

• Rules for ESOP approval
• Total ESOP pool options for the current lot
• Authorization of the board on granting options to the grantee
• Authorization for issuing shares to the grantee on the exercise of such options

Shareholder waivers and consents

There are times when the grantor opts to include precautionary rights on the issue of new shares in the company’s constitution and shareholders’ agreement. 

If such a clause is present, the ESOP committee will have to seek an approval from the shareholders holding precautionary rights by getting a waiver signed from them pertaining to the options being granted under the ESOP. 

Such a document can be prepared by the Company Secretary on behalf of the ESOP committee.

Granting options

• Start by preparing a set of directors’ resolution approving the grant of options to the list of recipients for the current ESOPs
• The grantor then sends a grant letter to each recipient containing the details of the options granted, exercise price, and the purported vesting schedule, along with an attached copy of the ESOP rules approved. If the grantee accepts the same, they will counter-sign the letter of grant and send it back
• Once the grantor receives the counter-signed letter, they will issue the option certificate to the grantee. The list of those accepting and turning down the offer is maintained internally along with the number of options granted, the expiry date, exercise price, vesting schedule, and the respective exercise dates.

Cliff and vest clauses

At times, companies may decide to issue shares periodically instead of all at once. So they can offer partial ESOPs after intervals, say after a year. In addition, there can also be a vesting cliff period. It refers to a period where no vesting occurs, but the benefit will be fully vested once the cliff (the specified time) is hit.

If the employee resigns during the cliff period, they are not eligible to receive any further stock options from the organization. Also, if the grantee resigns during the vesting period, they are eligible to receive pro-rated stock options or as previously decided by the organization.

Lock-in period

Most companies do not allow their employees to sell the stock they receive by exercising the option immediately. It means they can levy a lock-in period during which the employee will have to hold the stocks received.

An example of an ESOP

Suppose on January 1, 2021, Company X issues ESOP that enables you to receive 1,000 shares of the company at a strike price of SGD 300 per share on January 1, 2025. On January 20, 2025, the CMP of your company stands at SGD 400 per share. So you decide to exercise the option.

• The issue date is January 1, 2021
• The expiration date is January 1, 2025
• The exercise date is January 20, 2025
• The grant price is SGD 300 per share
• The current market price is SGD 400 per share
• If you want to exercise the options, you will have to buy the shares by paying SGD 300 for up to each stock (maximum 1,000). Given that the market price is higher than the exercise price, the ESOP offer seems beneficial for you. But there are several other factors you need to consider before deciding to take up the company shares.

Factors to be considered before implementing ESOPs

While ESOPs offer a plethora of advantages, but there are some factors to be kept in mind before a grantor implements it –

It is complicated and costly

Employee stock option plans entail a myriad of rules and regulations that companies must follow. In addition, these offer several scenarios for issuing, which can be confusing for relatively inexperienced management. The initial set-up cost of ESOP is high and requires professional help in most cases for a smooth flow of processes.

Equity percentage and dilution factor

Most entrepreneurs prefer closely-knit shareholdings for the companies they own. But if the organization plans on giving ESOP options, it would lead to equity dilution, which may not bode well for existing shareholders. 

While there is no set rule for ESOP size, most businesses set aside up to 15% of their allowed equity cap to be distributed to the employees, each getting up to 0.5% stake.

Such activities can often cause complications in acquisition or merger processes in future as option holders are able to influence decisions surrounding the business. Many companies only offer ESOs with drag-along rights where most minority shareholders would have to sell their stake if the organization receives an offer for sale or merger.  

Advantages and disadvantages of ESOP

Here are some of the reasons top companies love ESOPs –

It builds value

It is not only our business activities that help in building brand value. There are a plethora of additional activities that contribute to value addition, and ESOP is one of them. It allows the workforce to feel a sense of ownership. 

It propels them to stay motivated and excel at work, thereby helping the organization achieve its targets. In contrast, it leads to dilution in ownership which can impact the smooth flow of decision-making for the organization.

It helps retain vital talents

A successful organization is a combination of efficient human resources and technology working in tandem. Moreover, with ESOPs entailing vesting periods (of at least a few years), the organization can retain top talents by offering them part ownership of the company.

It helps reduce the cash part in remuneration

Most companies suffer from a shortage of free cash flow for efficiently handling their businesses. In such cases, they can use ESOPs as a part of the employee package to cover what they can offer and the corresponding market salary effortlessly. Having lower in-hand salary can be a disadvantage for the employees in the short run. 

Should an employee invest in ESOP?

From an employee’s perspective, there are several factors to be kept in mind while exercising ESOP. Here are the questions to be answered to help you determine if it is a good option for you –

• Do you have enough cash to invest in the options?
• Do you believe that the company has enough growth potential to ensure your investment is worth a shot?
• Does the company allow selling your shares immediately after exercising, or if there is a lock-in period, would you be comfortable holding them for so long?

Can an employee invest partially in ESOP?

An employee doesn’t need to exercise the option as soon as it vests with him. ESOPs come with an exercise period that allows investors time before the option expires. But exercising the option involves a sizable outflow of cash, and there is a taxation factor too. 

Plus, if the company is not listed, the money will be blocked in shares for longer. So it is imperative for the grantees to be wise and choose if they want to exercise their options or not. Singapore law allows partial vesting, i.e., employees can exercise their option partially.

Taxation of ESOP in Singapore

In usual cases, employees in Singapore are eligible to pay taxes to IRAS as per Singapore laws on any gains they derive from squaring their positions. Such income is treated as regular income and taxed as per the applicable tax slab for the individual.

In case a foreign employee in Singapore is granted ESOPs, the “deemed exercise” rule comes into play. Under this, employees are deemed to have derived gains from unexercised/restricted ESOPs when they cease to work in the country and with the employer who granted the options. Such rule applies to ESOPs and ESOWs (Employee Stock Ownership) issued on or after January 1, 2003. 

Here is how the notional gain is calculated – 

1. Open market price of the shares 

• On the grant date of ESOPs or ESOWs OR
• One month before the date when an employee ceases employment

Whichever is later. 

1. The exercise price of the shares under the unexercised/restricted ESOP offer OR

The prices paid or payable for acquiring the options under the ESOW agreement with vesting/moratorium imposed

The difference between (A) and (B) is the deemed taxable amount. 

However, if a Singapore resident is granted ESOPs during overseas employment, the gains are not deemed to be income generated in Singapore and hence not subject to taxes in Singapore.   

Conclusion

Stock options are becoming standard for most organizations, large or small, to attract and retain their valuable employees. 

While these may not be as straightforward as a retirement plan, these can often help employees generate a fortune. In addition, these also help entities to manage their free cash flow better. 

But these are complicated and entail a host of complexities for the offering organization so it is imperative for them to weigh the pros and cons before deciding if they want to move forward with the offer.

For more information, reach out to us at Intime Accounting.

References

https://mystartupequity.com/blog/esop-tax-implications-singapore/

https://www.investopedia.com/terms/e/eso.asp

https://corporatefinanceinstitute.com/resources/careers/compensation/employee-stock-option-eso/

https://www.futurebooks.com/demystifying-employee-stock-options-singapore/#:~:text=An%20ESOP%20Agreement%20authorises%20the,the%20shareholding%20of%20the%20company.&text=Company%20ABC%20currently%20has%2010%2C000%20shares%20fully%20paid%20by%20five%20shareholders.

https://singaporelegaladvice.com/law-articles/preparing-employee-stock-option-plan-esop-singapore/

https://www.iras.gov.sg/irashome/Individuals/Foreigners/Working-out-your-taxes/What-is-Taxable-What-is-Not/Stock-Options/#:~:text=Gains%20to%20IRAS-,Employee%20Share%20Option%20(ESOP),exercise%20of%20the%20share%20option.

https://sleek.com/sg/resources/a-beginners-guide-to-esops-in-singapore/

https://www.3ecpa.com.sg/resources/human-resource-immigration/employee-stock-option-plan-esop-in-singapore/

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https://www.twobirds.com/en/news/articles/2021/singapore/considerations-when-thinking-about-adopting-an-employee-share-option-scheme-for-your-business