Introduction to Employee Stock Option Plans
How to Set Up an Employee Stock Option Plan
As your company progresses over the years and grows in size, number of employees and revenue, the company and its employees will begin to enjoy the benefits of having an effective employee stock option plan or ESOP in place.
Some of these benefits may include increased motivation and productivity, a drive of top talent to your company and an increased sense of buy in for all stakeholders involved. For the employee, a major benefit of such a plan could be having a financially stable life (through investing in your company) up until and beyond retirement. For you, as an employer, it is a means of strengthening the bond between your company and your employees.
Either way, having a good ESOP in place and understanding the benefits it can accomplish is worth it for employers and employees in general.
By the end of this article, you will have a better understanding of how to set up an ESOP, how to grant stock options to employees, tax implications of ESOPs, how to account for ESOPs as well as other key aspects and benefits of launching ESOPs for your company or business.
Below is a brief list of key aspects of ESOPs and simplified details that you will find very useful.
Key Aspects of ESOP
What is an Employee Stock Option Plan?
Employee Stock Option Plans can be defined in many ways depending on the perspective or intention of the plan, to be succinct, it is simply a tool that companies use to further reward and incentivize their employees by giving them the opportunity to become part owners of the company through stock options.
There are different types of ESOPs that companies can utilize, some examples include; Employee Stock Purchase Plans, Stock Appreciation Rights or Employee Stock Option Schemes. The choice for you is purely based on the best fit for your company’s purposes and intentions of the plan. Your plans should address key issues like incentivising your employees through a retirement focused ESOP or scheme or increasing the sense of ownership amongst employees through a custom launched plan. As we discuss more aspects of ESOPs below, finding the right type for your company may become a little simpler to determine.
Setting Up Employee Stock Option Plans (ESOPs)
How do you set up an Employee Stock Option Plan?
There are a couple of steps to consider when setting up an ESOP, with success of your intended ESOP in mind, it would be sensible to do the following:
- Formally Document the Plan: If you are interested in launching a plan, you will need to work with a lawyer to formally document the plan, and define the different aspects of your chosen plan.
- Finalize on the Rights to Granting Stock Options: You need to agree on and state who the administrators are with the right to grant the stocks options based on the plan.
- Percentage of Stock Allocation: You need to determine the percentage of your company’s stock that will be allocated to employees that best suits your goals.
- Eligibility Criteria: Considering the fact that the plan will be offered to both old and new employees, there has to be set criteria that determine who exactly is eligible to take part in the stock option offers amongst your employees.
- Exercise Price: The price at which the options will be offered to the employees need to be agreed upon and stated in the documentation of the plan. The stock options could be offered at a discounted rate to employees when compared to the market value to incentivise a higher participation rate or it could be offered at the fair market value. The choice will be determined by the intention of the plan in terms of your goals for launching the ESOP.
- Vesting Period and Rights to Exercise: You will need to finalize this as well, taking into consideration the pros and cons at stake.
- Expiry Date of the Stock Options: An expiry date for the stock options detailed in a plan could assist in decision making on the part of the employee and improve participation rate. As an employer this date should be selected in line with your corporate goals and intention for launching the ESOP.
- Effect of Termination of Employment or Death of an Employee: There has to be a clear direction in terms of what happens to Stock Options issued to employees that have terminated their employment contracts or have become deceased while still retaining ownership of the stocks acquired through stock options. This will ensure sustainability of the plan.
Having this information finalized before issuing stock options to employees will allow your company to manage its goals when balancing planned percentages allocated for the ESOP and the available stock balance of the company. More importantly, finalizing these details will help reduce or manage diluted shareholdings efficiently for your company.
Granting stock options to Employees
How do you grant Employee Stock Option to Employees?
There are different ways to achieve this and as discussed above, the choice would be dependent on the desired intention of launching a plan for your company. Employees are typically granted options during their performance review.
The employees are given an option agreement that lists the number of stocks, the exercise price and vesting period (the purpose of the vesting period is to retain the employees and incentivise them to remain in the company for a minimum of the period allotted for vesting or ensure they stay for some time much longer than they would have stayed otherwise).
An important thing to note: Further to what has been detailed above, we would highly recommend that you issue the exercise price at the fair market value, otherwise there will be tax implications for your employees.
Exercising Vested Options
How can Employees exercise their vested options?
Based on the ESOP in place at your company, once some of the options vest, the employee can exercise (or issue the payment to formally obtain the shares and become a shareholder). As a shareholder, depending on the class of share they own, they can get dividends from their stocks when your company issues them.
Implications of Expired Stock Options
Stock Options may expire if they are not exercised by the employee after vesting. Such expired stock options are usually returned to the stock pool to be offered to other employees or used otherwise. Some stock options offer prices that are not at the fair market value as discussed above, some offer discounts or some other price conditions in conjunction with the options offering presented to the employee.
It is best practice to have a long expiry period at the fair market price with the aim of future acquisition as this scenario would mean that no payment is required for the options.
Tax Implications and Compliance
What are the Tax Implications of Launching an ESOP?
In order to remain compliant and minimize taxes as a company, it is useful to understand the tax implications of launching an ESOP, regardless of the type of tax (example: tax as a result of change of control or capital gains tax).
The advantages of having an appropriate ESOP and having it done by an expert or having it launched professionally cannot be overemphasized. As shown throughout this article, benefits like; increased motivation and productivity, improved sense of ownership amongst employees and a very good way to share your company’s success with your employees are all welcome ways of sustaining progress within the company.
If your company meets the criteria of LCGE, then the $50K (in the example above) will not be taxed and the employee can take that home tax free, provided the shares have been held for at least 2 years.
However, ESOPs need to be structured carefully or else they may become an issue down the road as tax implications and expense reporting can get complicated at year end, post launch of an ESOP. Thankfully we can help with that, reach out to us today to learn more! We look forward to hearing from and working with you to achieve your company’s goals.
Accounting for ESOPs
How can an ESOP be accounted for?
The fact that your ESOP is a type of expense for the company (non-cash), you will need to record that in your financial statements. To determine the value, you will need to use the Black Scholes model to value the options.
The journal entry would be:
Dr – Stock option expenses
Cr. – Contributed Surplus
For more of this and other expert services you could reach out to us for a professional perspective.
The advantages of having an appropriate ESOP and having it done by an expert or having it launched professionally cannot be overemphasized. As shown throughout this article, benefits like; increased motivation and productivity, improved sense of ownership amongst employees and a very good way to share your company’s success with your employees are all welcome ways of sustaining progress within the company.
However, ESOPs need to be structured carefully or else they may become an issue down the road as tax implications and expense reporting can get complicated at year end, post launch of an ESOP. Thankfully we can help with that, reach out to us today to learn more! We look forwarded to hearing from and working with you to achieve your company’s goals.
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