Guide to ESOPS

The VC Box

Abdulrahman Hammad

2021-04-21 20:23pm

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on:

The VC Box

Guide to ESOPS

The VC Box

Abdulrahman Hammad

2021-04-21 20:23pm

Share on:

Why is it Beneficial for Companies to Offer ESOPs? 


When employees have ESOP shares, they are shareholders in the company. The idea is that since employees are also owners in the business, they will have the company's best interest in mind at all times while employed at the company. With an additional stake in the future success of the company, they are incentivized to produce their best work.


Offering an ESOP has the following benefits to a company:


  • It retains highly-skilled employees;
  • It increases employee commitment and loyalty, boosting productivity;
  • It is a cost-effective alternative to monetary bonuses;
  • It attracts investors looking to invest in a forward-thinking business; and
  • It has potential tax benefits. 


Existing shareholders should be mindful of the unavoidable dilution that will result from the introduction of an ESOP. Nevertheless, shareholders are likely to agree to such dilution if it means that the workforce is dedicated to the success of the business, improving the chances of revenue growth and resulting increase in company valuation, which is to the benefit of all parties. 


ESOPs are particularly useful for companies that are in the early stages of their growth. An employee who is granted options at an early stage in the company's life cycle has a strong incentive to turn down a move to a larger company if it means that they have a chance at realizing large gains in the value of the stock as the company grows. 


How Does the Process Work?


The company's board has the final say in how the shares are allocated and administered. Employees, directors, and consultants of a company are all eligible to participate in an ESOP program depending on the needs of the company. The board should consider the maximum number of shares to be issued and how the shares will be apportioned, as well as the ESOP vesting schedule, which sets out the period of time an employee or beneficiary must remain at the company before receiving his/her shares. 


Typically, a portion of ESOP shares will vest each year of service. If the participating employee stays a certain number of years, their ESOP shares are considered fully vested and the employee is thereafter able to benefit from the value of their entire shares. It is common practice to vest the ESOP shares over four years, with the first portion of shares vesting in one lump sum at the end of the first year (what is known as a one-year "cliff"). By way of example, a typical ESOP plan might include a one-year cliff for 25% of the shares, with the remaining 75% of the shares to vest in quarterly or monthly increments over the subsequent three years. 


If an employee leaves before being fully vested, the unvested grants will be cancelled. Once fully vested, it is immaterial if the employee is retiring or leaving for another job as they will have the full economic benefits of the shares. Many ESOP plans that grant legal title to the shares include an option for the company to "buy back" the vested shares, which permits the company to redistribute repurchased shares to one or more employees, or cancel the shares altogether. Employees should be made aware that the granting of ESOP shares does not provide any guarantee of continued employment with the company.

 

There is usually no up-front cost to the participating employees as the ESOP shares are offered as part of the employee’s compensation package. ESOP shares do not customarily possess voting, information, or conversion rights for the holders. However, if a company undergoes an acquisition, the underlying shares may, subject to the terms of the transaction, be converted into ordinary shares in the acquiring company and benefit from the rights granted to such shares.


ESOPs in the United States


Companies in the US have long used ESOPs as a tax-qualified retirement program allowing employees to acquire shares in the company. They have become particularly popular with startups and emerging companies in the technology industry that unable to offer skilled workers the high wages that they can command elsewhere, but instead can offer shares in the business and a chance to be part of the growth story. 

ESOPs in the United States generally operate through a trust, set up by the company, that accepts tax deductible contributions from the company to purchase company stock. The company is therefore offered the ability to reduce its corporate income taxes and increase its cash flow by issuing newly issued stock to its ESOP. Employee participation in the plan may be contingent on a minimum number of years of service to the company. Companies should carefully consider tax implications of the length and manner of the vesting schedule. 

Fiduciary obligations exist on the trustees who manage the ESOP, as regulated by the Employee Retirement Income Security Act (ERISA) and implemented by the Department of Labor and the Internal Revenue Service. Trustees must act in the best interests of the employees to whom such ESOP shares are credited, and may be liable if found to have knowingly participated in improper transactions. 


ESOPs in the United Kingdom


The government of the United Kingdom supports and encourages companies to implement ESOPs. In fact, over 2 million employees in the United Kingdom hold employee shares. Shares acquired under the main types of employee share incentive schemes, including the Company Share Option Plan (CSOP), the Enterprise Management Initiatives (EMI), the "Save As You Earn" Share Schemes (SAY) or the Share Inventive Plan (SIP), are generally free from income tax and National Insurance contributions and are therefore a cost-effective method of compensating employees. 

The United Kingdom allows both public and private companies to offer an employee stock ownership plan. However, when it comes to private, unlisted companies, employee ownership typically does not exceed 10%. 


ESOPs in Saudi Arabia


It is not yet commonplace for Saudi companies to offer employees company shares. An increased sophistication among private investors, when combined with recent efforts to boost the private sector to diversify the economy, has resulted in more Saudi companies, and start-ups in particular, offering this benefit plan to employees.


Governmental Regulations of ESOPs


Neither Sharia law nor statutory law dictates how employee stock ownership plans must be carried out by companies that choose to offer them. This provides companies discretionary freedom to tailor their ESOP to fit the needs of both the company and the employees, and to modify it as their needs may change. However, stipulations exist on the rights of both the employee and the company when it comes time to "cash-out". 

Resident companies in Saudi Arabia must be mindful of the tax implications of offering ESOP shares to foreign employees operating in the Kingdom as the company will be subject to a 20% tax on income generated by shares owned by non-Saudi shareholders. 

Publicly listed companies are additionally subject to the Securities Depository Centre Rules of the Capital Markets Authority, whereby shares can only be offered to employees who have been registered with the Saudi Stock Exchange.


Foreign Parent Companies


Foreign parent companies that have operations in Saudi Arabia can offer ESOPs to employees. This is most typically done to: 


  • increase incentives offered to those who are not employees; and
  • avoid restrictions on the offering of shares to foreign employees operating in the Kingdom.


Administering the ESOP


In the early stages of a company, the board of directors is usually appointed as the administrator of the ESOP, and may delegate such responsibility to a committee as the company grows. Recently, we have witnessed a proliferation of third-party service providers that offer to act as an administrator or trustee of the ESOP, with the responsibility of ensuring that the ESOP is operated in accordance with the plan document approved by the board, and that the required information is reported to both regulators and participants. 

The decision by the board to appoint a service provider will come down to balancing the cost of the service against the benefits of appointing a third party. Such benefits include assigning fiduciary risk away from management, as well as freeing up of time which the board can instead redirect towards growing the company.