ESOP

Employee share or option program - what, how and why?

The recipe for building a kick-ass team: Well-designed employee stock and option programs (ESOP). It can be very powerful, and at the same time very cost-effective.

In this blog post, you will learn more about employee share and option programs (ESOP):

  • Why it's important for companies to use this tool
  • The different types of schemes you can choose from
  • Tax considerations
  • Different conditions to consider
  • The importance of good design, management and communication
  • Some considerations on the size of the program

One of the most important jobs of any CEO is to recruit and retain talent. With the current talent war in a great job market, this is more difficult than ever. This is where ESOP can have a very powerful effect.

Let's start by defining the concept of share and option programs. We're talking about giving employees ownership incentives in the company they work for, so that they can share in the value creation they contribute to. This has many positive effects, which we will come back to. This is a key part of the playbook of all companies in Silicon Valley, where they have coined the term "Employee Stock Ownership Plans", ESOP for short.

Investopedia uses the following definition for ESOP:

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

It includes all possible incentive schemes for employees that are linked to shares in one way or another, including options. In Norway, we do not yet have a common term. Some people just call it an incentive scheme, others call it options, share scheme, ownership, share salary, etc. This is a matter of definition, and to be completely accurate, it is difficult to find a common term. We have chosen to call it a share and option program for now, but for the sake of simplicity we will refer to ESOP throughout this blog post.

Implementing an ESOP program is probably the most effective decision a company can make to ensure long-term motivation for their team. Many companies, especially early stage companies, also actively use ESOPs as part of their compensation package to reduce labor costs during a critical phase.

Continue reading this blog post to understand why you should consider this for your business and to get a better understanding of what it entails.

A highly motivated team 👫

Owning part of the company has a highly motivating effect for most people. In fact, it can be so powerful that in many cases it gives individual employees a "purpose". They get the feeling that they are building something for themselves and a community.

Co-ownership also creates a solid team culture, or a so-called "us" culture. It makes employees more tolerant of the hard work and tough times many early-stage companies go through.

Statistics also show that this can help make employees less opportunistic in these tough times, where employees without ownership may be more inclined to look for other job opportunities instead of helping the company through the tough times.

In general, well-designed ESOP programs help retain key personnel for a longer period of time and work towards common goals.

Many companies also use ESOP programs to attract more talented external board members.

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Save costs with reduced salaries 💰

Most companies that actively use ESOP as a tool use it as part of their overall compensation package. This can therefore have a strong effect on the economy as salaries are usually the biggest cost.

This is often a must in early-stage companies, as most startups don't have the same ability to pay high salaries in the beginning. It can be compared to an investment on the part of the employees.

This is something early-stage investors find beneficial and even expect. Not only because it's good for the company's finances, but also because the team has what they call "skin in the game", showing commitment and belief in the company by trading safe money for potential upside. Learn more about how ESOPs can help you reduce salaries in this blog post.

Different types of equity and plans 📄

ESOP programs can take many forms with different types of instruments (schemes).

The most common schemes are restricted shares, which we call Restricted Stock Awards (RSA) or stock options, often referred to simply as shares and options. But there are also other types that can be considered, such as Restricted Stock Units (RSI) or synthetic schemes.

The main difference between shares and stock options is that shares are actual/current ownership in the company with associated benefits, and stock options are the right to buy shares in the future at a predetermined price. Find more about it in our dedicated blog post that elaborates on the difference more.

The fact that a company has to decide which equity and ESOP structure to go for makes this a complex decision as there are various considerations to think about, such as costs, tax implications, incentive effect, legal considerations, practical considerations and so on.

There are many factors to consider when choosing an ESOP program. In our opinion, the best structured programs have the maximum motivational effect, retention effect, while minimizing costs and tax burdens for employees.

Tax and cost considerations 💸

The stage the company is in at the time the ESOP program is implemented is often the driving factor in the choice of program type. The reason is the implication on the cost of participating in the program and the corresponding tax consequences. In other words, the short- and long-term financial impact of the plan for the employees.

From a tax perspective, any financial benefits associated with employment in a company shall be taxed as income tax. Therefore, the basic principle is that benefits from options should be taxed as income. In contrast, a gain on an actual investment (at market price) is taxable as capital income. This is important as tax on income is often higher than tax on capital income. If you invest via a holding company, you may also be eligible for the exemption method.

Several countries, including Norway, have special schemes for early-stage companies to stimulate value creation and economic growth. In recent years, legislative changes have therefore been made to make options more favorable for tax purposes. However, there are strict requirements for the option, the company and the employees to qualify for this. See a separate blog post about this here

ESOP programs such as Stock Options, Restricted Stock Units (RSU) and Phantom Shares are all structures that, in principle, fall under the income category and are taxed accordingly. This is because the employees receive a benefit as a result of their employment. The exception to this common rule is any tax exemptions as mentioned above, this is more common for stock options. NB: Shares sold below market price are also considered an employee benefit and are immediately taxed according to the income rule.

Having covered tax implications, we would add that companies should strive to minimize the tax impact on employees to the best of their ability. In cases where a company cannot use special tax exemptions, it is best to structure the plan so that any financial reward is considered a capital gain if possible.

Then you have to look at direct ownership through the purchase of shares. There are also a few different ways of doing this. Perhaps the most commonly used, we refer to as Restricted Stock Awards (RSA). This essentially means the allocation of shares with certain restrictions, which we will describe more in the terms and conditions section.

Now that we've covered options and RSAs, let's give you a couple of examples of why timing is important when choosing which structure to use. Let's say you want to offer employees an ESOP for the scenarios below:

Scenario 1: The company has a high (Fair Market) valuation

Employees must either:

  1. Pay a fair market price for the shares. The employees then take a real risk and it is not considered compensation. Any gain will be taxed as a capital gain. The challenge is that in many cases employees do not have the financial ability (or risk appetite) to do so.
  2. Pay a discounted price for the shares. This will immediately trigger a tax claim for the price difference between what they pay and the market price, which is taxed as income tax. Note that any additional gains will be taxed as capital gains. Here we have the same challenge as above with financial capacity and risk.
  3. They can get an option plan. They don't have to pay anything when they receive the options, there is no immediate tax liability and they take no risk. But they do have to pay if they want to exercise the options later (convert to shares). But there are some restrictions on options. And any gains on exercise will be taxed as income tax. The challenge can be that the shares are not tradable, so employees can face a financial squeeze unless they qualify for options for startups.

Scenario 2: The company has a low (Fair Market) valuation

This is often before the company has completed a share issue with some external investors. Then the company has more leeway when it comes to the ESOP program. Now employees can buy shares at a very low price. An RSA plan is often the best option. This is now both affordable and advantageous from a tax perspective as any gains are taxed as capital gains, or come under the exemption method.

Notes: There are ways to make the RSA structure practicable even after taking external investments. We will cover more on this in a separate blog post later. One option to consider is the leveraged buyout model (often called the Kruse Smith model). You can read more in this blog post.

Terms and conditions 📑

Another factor that complicates the structuring of ESOPs is the many difficult legal terms that are often used in the agreements, which are often also referred to in English with a lack of appropriate Norwegian words.

These conditions are mainly put in place to provide the desired motivational effect to the employee or to protect the company against undesirable scenarios. This is a means for companies to avoid ending up with a so-called "broken" and unfundable cap table (shareholder book). This often means that much of the ownership is left with people who do not work in or contribute to the company.

One of the most common terms is vesting. This determines how employees earn the right to retain shares, exercise options or settle RSUs. This can be either 1) time-based, how long an employee needs to work for the company, or 2) condition-based, often based on performance or sales/listing, or 3) a combination of these. Shares or options are often partially vested at certain thresholds. And often a Cliff (threshold) period is also included, meaning an initial period the employee must work with the company to retain any rights.

Other typical things an ESOP program often includes are post-termination clauses for certain scenarios, plan expiration date, lockup period, pre-emption rights, etc. Some of these things can also be addressed in a shareholders' agreement (SHA), especially for working shareholders.

Other things to be aware of are share classes. A company may have certain share classes on its issued shares. This can affect voting rights, dividends and payment preferences.

In short, ESOP structures have an element of risk for both the employee and the company. A well-designed ESOP structure and agreement can reduce this risk for both parties. We will cover more about this and the terms in general in a separate blog post later.

Communication, consistency and fairness 🌟

As with all things in business, communication is important, but often not taken seriously enough. When creating an ESOP program, many different stakeholders may be involved. Entrepreneurs, management, different types of investors, the board, existing employees, new employees, etc.

Good communication all the way from the start and throughout the process is essential. This helps to structure a fair plan and a motivating plan that works for many, a plan that is more likely to be approved or accepted, plus it helps to reduce friction and disappointment.

We have seen many managers make empty promises to employees about EOSP programs, but fail to deliver on their implementation. This is a complex domain and many important factors to consider, which often leads to managers delaying decisions. It can be delayed to the point where the desired or most optimal program type is not feasible for various reasons. This often leads to frustration among the team and can result in employees leaving the company.

Communication throughout the planning period is also helpful in keeping employees motivated and making them feel included.

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

ESOP program size📚

A question we are often asked is how much of the shares should be allocated to an ESOP program, many call this a pool or pot. This is not an exact science, and it depends on the company's ambitions, how many employees and what type of employees a company needs and timeline. But somewhere between 10-20% is often considered normal. This is in addition to the founding team sitting with all or most of the shares before taking any external investments.

It is also very common for the ESOP pot to be replenished at each investment round, which is often followed by a need to hire people. This is usually the time when a need for different types of ESOP structures becomes necessary.

If a company is on a venture journey and raises capital in several rounds, this often has a self-regulating effect. When the company raises more capital, there will be more outstanding shares. More shares can then be allocated to the ESOP pot to maintain the same percentage of shares available for the ESOP program

How much share to give to each person is also something that should be carefully considered. First, we must try to look into the future of the business and try to predict employee needs and create a plan that works in the long run. It should also be fair. If you get the distribution wrong, you can end up with unhappy employees. It's okay for employees who start earlier to get a higher pot than employees who start later. And it's okay for senior employees in higher positions to get a higher pot than more junior roles. But the general principle should be fairness. Consider it part of the compensation package. This is often dependent on seniority or the role. Another consideration is that if one takes a higher pay cut than another, you can again compensate with ESOP.

Although the E in ESOP refers to employees, it is not limited to employees. It's not uncommon to also compensate directors or advisors with equity. This is particularly useful in the early days of a business, when cash is a scarcity, when you have little to show for it, a small team and thus the need for solid contributors is higher. Be aware that different conditions/tax rules may apply to these, especially when it comes to options.

Having external contributors (other than employees), who are compensated with equity, is often referred to as "sweat for equity". This is a good practice to help you get started. But be mindful of how much equity you give away at this point, you still need to plan for the long term and protect ownership. If you give away too much equity at the start, it can come back to haunt you later when you try to raise new capital. We'll cover more about this in a separate blog post.

Other factors

There are many other factors that we haven't covered in this blog post, which we will cover in more detail in other posts. These include, but are not limited to:

Source of the shares (newly issued shares, treasury shares, secondary shares), investor expectations and often requirements. Setting up a new share pool pre- or post-money when raising capital and the associated dilution effect. Accelerated vesting. Employee use of a holding company. Accounting and reporting requirements. Tax requirements, etc.

ESOP software and advice 🤝

The domain is complex and requires management both when implementing a program and throughout the program. A software to manage this will save companies precious time and money. In addition, it gives the company full control and compliance while keeping employees updated and motivated.

Lawyers have stated that our software that handles process support for options and provides insight into fully diluted ownership can save 10% of the time of CEO/CFOs in growth companies.

Our software will initially help you implement all plans, guide you through the process using wizards and send the ESOP plans for electronic signatures. The documents will be stored in a dedicated document center that ensures full traceability, easy access, full control and makes the share book and transactions match. This is not only important for business owners to have full control of ownership, but also a must when raising capital.

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

The company manager (admin user) has a good overview of all ESOPs in the company and can manage them from one place. Both adding new ones, editing old ones, updating stakeholders, exercising stock options, etc.

Similarly, employees get their own dashboard with all information, such as plan details, development, earning plans 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 share register overview, which includes not only actual shares, but also share rights. You can see and simulate how convertible loans, options etc. can affect the ownership distribution in the company in different scenarios.

The notification center will keep everyone up to date, inform them of changes, nudge them to take the necessary actions and send reminders when needed. This will reduce both risk and administrative burden around the necessary follow-up of 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 transfer funds and the manager will in turn issue the shares. This is handled seamlessly through the software and significantly reduces the admin burden.

The other side of this is the accounting and reporting requirements. Stock options need to be expensed and there are tax requirements for employees and, in some cases, companies. Having a system that can report and predict the necessary numbers is a time saver and helps managers stay in control.

Conclusion

When building teams and a culture of high performance, few things are more impactful than implementing an ESOP program for employees. The beauty of this is that it can also help reduce costs. Two things that are very important in both the early and growth phases of a company.

However, ESOP programs are a complex domain, both from a legal, tax, cost and practical perspective. There are many things to consider. Doing things the right way from the beginning is very important. There are some best practices and there are some common pitfalls you should be aware of.

Trying to figure everything out yourself will require a lot of time, and there is a high risk of making mistakes that could prove critical in many ways in the long run. Often you don't know this until it's too late. Using accountants and lawyers for this can often seem like the only way out. This is also often very expensive. They can give you legal advice, but may not always be the best from a practical, business or company-building perspective.

We specialize in helping companies analyze their business phase and needs to create the right plan at the right time. From a cost, tax, risk and motivation perspective. This changes as the company evolves. And it's also important to try to plan for the long term.

Both implementation and management can be demanding and time-consuming. There are great benefits to consulting with experts in the field during the implementation process and using a software that can save you valuable time and costs and keep you in complete control.

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

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