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Guide to implementing an Employee Stock Option Plan (ESOPs)

patricia-borlovan

Patricia Borlovan

· 4 min read
Guide to implementing an Employee Stock Option Plan (ESOPs)
Welcome to our guide on how to implement an Employee Stock Option Plan (ESOP) in your company. We have tried to provide you with a detailed understanding of this interesting form of employee compensation and ownership, while keeping everything fast and simple. Although we may not cover all the details you may need for your specific company and situation, rest assured that we're here to provide you with a solid foundation to embark on your ESOP journey.

1: What is an Employee Stock Option Plan (ESOP)?

An ESOP is a structured compensation scheme which your company may offer to your employees. By making some of them part of your company’s ESOP, they will get the option to purchase company shares at a predetermined price, so that in the end they may own a piece of your company. The primary motivation behind ESOPs is to ensure that your employees’ interests align with your company's long-term growth and success. You could find some more general info here .

  • Are there more types of ESOPs? ESOPs may take different forms, each with its characteristics. Depending on your decision, you may offer your employees options to purchase company shares at a specific price, grant them actual shares upfront, or give them cash equivalents tied to company stock performance (phantom stock). You could choose one or another based on your company's objectives and what works best for the employees.
  • Is anything common to all these ESOP types? ESOPs are not universally applicable to any employee, and often you may decide to restrict them to some categories of employees, based on factors such as job roles, tenure, performance, and individual qualifications. However, vesting is a core principle present in all ESOPs. Vesting represents a timeframe over which employees may gain ownership rights to the granted options or shares. Motivating them over time, instead of immediately, is meant to encourage their loyalty and engagement, as it rewards their ongoing commitment to the company's growth.
  • Which employees get to be part of the ESOP? Offering to an employee ESOP participation depends on a combination of factors, which may include their tenure with the company, their individual performance metrics, and sometimes, if they leave the company, their exit status (good or bad leaver). You should define these criteria at company level to ensure that employees who contribute positively to the company's objectives are the ones benefiting from the ESOP.

For more details about possible types of ESOPs you should check the following article

‍2: Is ESOP better or worse than cash bonuses?

Well, as always, there are advantages and disadvantages to every situation. Although employees may prefer one or the other, typically you should decide on a specific mix of ESOP and cash-based rewards for employees, and then implement this in the compensation packages, tied to specific performance items you consider critical for the company. 

  • ESOP advantages. Rewarding your employees through an ESOP may give them several compelling advantages. The value of their options or shares can appreciate over time, providing them with a potential financial gain. Additionally, ESOPs often come with tax benefits, allowing you and them to pay less taxes, or to pay them later, than if you decide to motivate them through a cash reward (typically both). It may be easier also for the company to give them options or shares than cash, as cash is precious to ensure company growth. Furthermore, during equity events such as acquisitions or initial public offerings (IPOs), your employees may stand to realize significant profits from their ownership stakes.
  • ESOP disadvantages. Where’s no pain, there may be no gain. Accessing the ESOP’s advantages comes with some features that may be difficult for the employees. The main one is the potential need for upfront capital to exercise options or purchase shares. Additionally, there may be a time delay before they can fully benefit from their ownership stake. Furthermore, they will participate to all your company ups and downs, will need to be consulted for votes, and generally will add in your captable extra shareholders that you need to take care of. Implementing and managing an ESOP requires some paperwork, legal advice, time and energy from a dedicated person or even team.

You could get more practical insights about creating and managing an ESOP here

3. Which are the main steps to implement an ESOP in my company?

If you plan to implement an ESOP in your company, you should navigate through the following key phases:

  • Plan Design: You should determine the objectives of your ESOP, including the desired level of employee ownership, participation criteria, and the allocation of options or shares. You should make sure that the plan aligns with your company's growth trajectory and financial situation and goals.
  • Documentation: Once you thought out your ESOP, it is time to document is. You must create comprehensive documents outlining the terms and conditions of the plan. These documents should cover aspects such as eligibility criteria, vesting schedules, exercise procedures, and potential adjustments based on significant corporate events. Although you may find some templates on our resources section, we also recommend talking to a lawyer to make sure you know all necessary details.
  • Communication: The plan has no value if employees don’t know about it. You should communicate the ESOP to your employees, ensuring they understand the benefits, mechanics, and potential outcomes of participation. You should be as transparent as possible, as this will generate trust and hopefully lead to active engagement.
  • Implementation: Now you are ready to launch the ESOP and facilitate the granting of options or shares to eligible employees. This involves the formal process of awarding ownership rights according to the predetermined terms.
  • Vesting and Monitoring: Throughout the life of the plan, you should monitor employees' vesting progress and ownership status, and at the same time keep employees informed at all times about their vesting schedules and milestones. As this is a relatively finicky task that should be done right, we think that relying only on spreadsheets and paper files will not be enough.

You could find useful information also here.

Keeping track of what’s going on during all these phases, managing internally the ESOP and giving your employees the possibility to follow the vested options and exercise them may be confusing for both you and them. Nimity solves all your worries, so just register the ESOP at www.nimity.com, and then invite your employees to open accounts with us.

4. How do I grant shares to eligible employees?

  • How do I decide how many shares or options to grant? The decision to grant options or shares to employees is typically made by the company's management team or board of directors. These decisions align with the company's goals and the desired employee participation in ownership. Some employees may negotiate how many shares / options they will be granted when they start working for the company, or upon some promotion, but other than that, once decided, the granted stock / options packages are likely to remain unchanged.
  • So there will be no changes once shares / options are granted? While changes to granted shares or options are relatively uncommon, they may occur under specific circumstances, such as changes in company structure, regulatory requirements. Also, if employees are getting a new position, or in case of exceptional performance, they may renegotiate their ESOP package. Significant corporate events, such as financing rounds or listings on stock exchanges, can impact the value and accessibility of options or shares. These events can lead to revaluation of options or shares and may trigger adjustments to the terms and conditions of the ESOP.
  • Is there a specific negotiation period? The terms and conditions of granting options or shares are usually negotiated during the employee onboarding process or at specific intervals, depending on company policies. So be sure to include the relevant information in the documents about the ESOP.
  • How do employees see the status of their shares / options? Typically, thoughtful companies provide their employees with a tool or platform allowing them to track their granted options or shares and ensure visibility into their ownership stake.

All steps in your employees’ participation to the ESOP are visible in their Nimity account 

5: Explain more about Vesting

Vesting is a concept which is always found at the core of any ESOP, as it rewards employees' loyalty and sustained commitment (meaning the company rewards stable and productive employees). By tying ownership rights to their time with the company or performance milestones, vesting should encourage them to remain engaged and contribute to the company's growth.

  • Are there more vesting types? There are two primary types of vesting: time-based and milestone based. Time-based vesting will rely on the employee’s length of service, gradually unlocking ownership rights over a predetermined period. Milestone-based vesting, on the other hand, is tied to achieving specific goals or milestones (the employee’s or the company’s), resulting in ownership rights upon successful accomplishment.
  • What is a Vesting Schedule? A vesting schedule outlines the timeline over which an employee will gain ownership rights to the granted options or shares. This schedule is a crucial reference point for the employee, providing clarity on when the ownership rights could be exercised. In some cases (acquisition, investment round, IPO), you could accelerate vesting schedules, meaning all the shares / options still not vested may vest immediately.
  • What are Vesting Conditions? Detailed vesting conditions, including the specific milestones or performance metrics, are usually outlined in official company documents or designated platforms. These conditions provide a transparent framework for employees to see exactly where they are standing in their progress towards ownership.
  • Is there a way to present the employees their vesting situation? The employee dashboard in the Nimity platform which shows them the granting situation (see the section above) is also allowing them to also see which shares / options are vested, and also to exercise them (see below). 

6: How do employees exercise their Options?

  • Do employees need to pay to get shares / options? Exercising options or purchasing shares under an ESOP may require the employees to pay a certain price. This applies to either purchasing the options at the predetermined strike price or directly buying shares. This price may be lower than the market price for the shares, but nevertheless it may represent a significant amount for the employee.
  • Do employees need to exercise all their vested shares / options? Typically, employees are often granted the flexibility to exercise only a portion of their vested options, enabling them to manage their financial commitments strategically. So, they could choose to exercise only part of their vested shares / options, or even none at all.
  • Should the employee decide immediately upon vesting how many shares / options to exercise? The employees are not obliged to exercise their vested options immediately upon becoming eligible. They can choose when to exercise within a specified timeframe, allowing them to consider market conditions and their personal financial situation. However, this timeframe may be limited, so after a while, if they do not exercise them, their shares / options may be lost.
  • Do employees or the company need to pay taxes upon exercising?  When employees exercise their options or purchase shares, there’s always a tax obligation attached. However, how many taxes each of the parties should pay and when depends on factors such as the timing of exercise, the difference between the strike price and the market value, and local tax regulations. In each country there are some tax advantages for companies / ESOP members, so be sure to check the specific conditions in your case with your legal advisor. 
  • What happens after employees get the shares? Upon exercising options or purchasing shares, employees become partial owners of the company, with the potential to benefit from any future appreciation in share value. If the value of the company grows, their share of the company increases too. If the company does not perform well, their shares may lose value.

Exercising options is made easy by dedicated buttons in the employee ESOP dashboard, at www.nimity.com.

7: I have some other questions

  • What happens if an employee leaves the company during the vesting period? Employees who leave the company may have different outcomes for their vested options or shares based on their exit classification. Those deemed "good leavers," typically leaving for reasons such as retirement or amicable departures, may retain ownership rights. "Bad leavers," who exit under less favorable circumstances, may face restrictions on ownership rights or have to relinquish them. However, shares they already own when they are leaving remain theirs under any circumstances.
  • Could employees sell their shares / options? In some cases, the employees may have the option to sell their vested shares or options. However, this is subject to the company's policies, regulatory considerations, and any contractual restrictions. Selling can provide employees with liquidity and the opportunity to realize value from their ownership stake.
  • How do employees know the value of their shares / options? Determining the value of options or shares in an ESOP can be complex and is often tied to various factors. These factors include the company's financial performance, industry trends, market conditions, and potential future equity events. Valuation methods may involve the engagement of professional valuation experts to ensure accuracy and fairness. Companies who implement ESOPs usually perform such valuations from time to time, as in some countries this is required by law, while in other countries, even if not mandatory, the company does valuations from time to time for the benefit of the ESOP employees and shareholders.‍

Profit / loss calculation example

Let's calculate your profit or loss if an employee buys ESOP shares in your company under different scenarios. Let’s say the employee buys ESOP shares worth 1,000 EUR, at a strike price of 0.85 EUR at a moment when the company value is 1 mil EUR, and the share price is 1 EUR. We consider the following situations:

  1. The company value stays the same

  2. The company value diminishes at 900.000 EUR

  3. The company value diminishes at 500.000 EUR

  4. The company value increases at 3 mil EUR.

Initial Information:

  • Current Company Value: 1,000,000 EUR
  • Strike Price: 0.85 EUR (The price at which the employee purchases the shares)
  • Share Price: 1 EUR (The market price per share at the moment of calculation)

Scenario 1: Company Value Stays the Same

  • Profit/Loss = (Share Price - Strike Price) * Number of Shares
  • Number of Shares = Invested Amount / Strike Price
  • Assuming the employee invests 850 EUR (1000 shares):
  • Number of Shares = 850 EUR / 0.85 EUR = 1000 shares
  • Profit/Loss = (1 EUR - 0.85 EUR) * 1000 shares = 150 EUR (Profit)

Scenario 2: Company Value Diminishes to 900,000 EUR

  • New Share Price = 0.90 EUR/share
  • Profit/Loss = (New Share Price - Strike Price) * Number of Shares
  • Profit/Loss = (0.90 EUR - 0.85 EUR) * 1000 shares = 50 EUR (Profit)

Scenario 3: Company Value Diminishes to 500,000 EUR

  • New Share Price = 0.5 EUR/share
  • Profit/Loss = (New Share Price - Strike Price) * Number of Shares
  • Profit/Loss = (0.5 EUR - 0.85 EUR) * 1000 shares = -350 EUR (Loss)

Scenario 4: Company Value Increases to 3,000,000 EUR

  • New Share Price = 3 EUR/share
  • Profit/Loss = (New Share Price - Strike Price) * Number of Shares
  • Profit/Loss = (3 EUR - 0.85 EUR) * 1000 shares = 2,150 EUR (Profit)

In summary, the employee profit or loss from buying ESOP shares depends on the change in company value and share price. In Scenario 1, 2 and 4, the employee experiences profits due to increases in company value or share price. However, in Scenario 3, the employee incurs losses due to decreases in company value and thus the share price. Even if the company value decreases, as long as the company share price remains over the strike price, employees win. If the share price decreases below this limit, employees lose.

8: What could Nimity do for me?

  • Nimity's Role: Nimity serves as a comprehensive platform designed to allow effective management and of ESOPs, streamlining various aspects of the process for both employees, employers and the company.
  • Tracking Options/Shares: Nimity provides the company with a centralized view of the granted options or shares. Using Nimity will keep you informed about your employees’ ownership status.
  • Vesting Schedule Monitoring: You can rely on Nimity to monitor vesting schedules. This feature ensures that you are well aware at all times of your employees’ progress toward exercising their ownership rights based on predetermined milestones.
  • Facilitating Exercise: Nimity streamlines the exercising process, simplifying the steps involved in converting options into shares or purchasing shares at the strike price. This streamlined process minimizes administrative hurdles and decreases time spent on administrative tasks.
  • Complete Overview: Nimity's platform offers you a detailed view of all ESOPs created in your company. This is designed to allow you informed decision-making and a clear understanding of your employees’ cumulative ownership.
  • Secondary Market Access: Nimity will provide your employees in the future with access to a secondary market for buying or selling shares/options. This market offers liquidity and flexibility, and will allow them to manage their ownership portfolio based on changing financial needs or market conditions.

Remember: you could access all these features and more by opening a company account at www.nimity.com and inviting your employees to use Nimity tools and dashboards.

9: What do some key terms mean

  • Options: Options represent the right granted to the employee to purchase company shares at a predetermined price within a specified timeframe.
  • Shares: Shares denote ownership units in a company. If employees own shares, they have a stake in the company's performance and growth.
  • Granting: Granting is the process by which your company allocates options or shares to the employees, outlining the terms and conditions under which these ownership rights are offered.
  • Vesting: Vesting refers to employees’ gradual accumulation of ownership rights over time or upon meeting specific performance milestones. Vesting should incentivize them to remain engaged with the company and its long-term objectives.
  • Milestone: A milestone is a significant achievement or performance goal that, when met, triggers vesting of ownership rights. Milestones are often tied to the company's strategic objectives.
  • Exercising: Exercising involves the conversion of vested options into actual shares or the direct purchase of company shares. This action allows the employees to become partial owners of the company.
  • Strike Price: The strike price, also known as the exercise price, is the predetermined price at which employees can purchase company shares when exercising options.
  • Good Leaver/Bad Leaver: These terms categorize departing employees based on the circumstances of their exit. "Good leavers" exit on positive terms, while "bad leavers" exit due to circumstances less favorable to the company.
  • Secondary Transaction: A secondary transaction refers to the buying or selling of shares/options in a secondary market after the initial granting phase. This secondary market provides employees with liquidity and flexibility.
  • Equity Event: An equity event refers to a significant corporate occurrence that impacts the ownership structure of the company. Examples include mergers, acquisitions, initial public offerings (IPOs), and financing rounds.‍

At the end

We hope this guide has allowed you to gain a solid understanding of ESOPs in general, and hopefully the ones implemented in your company. Now you're better prepared to navigate your journey as a company founder or ESOP manager, and make informed decisions about all the steps you need to design, implement, operate and monitor your company’s ESOP. Please check our platform and web based resources if you want to know more, and do not hesitate to contact us for specific issues related to Nimity.

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