Considerations when thinking about adopting an Employee Share Option Scheme for your business

The ESOS rules to be aware of

Any ESOS that is adopted should be in the form of clear and precise rules that set out the structure of the scheme. The rules should include:

1. The eligibility criteria for employees to participate in the ESOS;
2. the size of the option pool;
3. the option price, exercise price and vesting period;
4. the rights of the underlying shares;
5. consequences of an employee leaving the company; and
6. consequences of a liquidity event of the company.

How big is your pool?

While there is no hard and fast rule about how big the ESOS pool should be, the market convention can range from between 7.5% to 15% of the issued and paid-up share capital of the company. Certain venture capital investors may require the company to adopt an ESOS as part of their investment conditions to retain talent and also control cash burn. It is important that founders and investors agree on the option strategy and the limits on the ESOS pool upfront. To keep in mind, this may represent a further dilution on top of the valuation negotiated by the founders for the investment.

An increase in the option pool may also be required as the company matures and moves through various rounds of fund raising. Whether such increase is based on the pre or post-money share capital of any investment round will determine whether the incoming investors will also share in the costs of dilution.

Nuts and bolts: Option Price, Exercise Price & Vesting Period

The option price is the amount the employees pay the company to receive the options. The pricing may vary and different jurisdictions may have rules around minimum pricing for such options. In most cases, in order to incentivise the employees to receive the options, these are granted for free or at a nominal consideration.

The exercise price is the amount the employee must pay to the company when exercising the option. This is typically determined at the discretion of the board (or the committee responsible for administering the ESOS), at either a nominal value, or the fair market value of the shares at the time of grant. Where the option has an exercise price equal to the fair market value at the time of the grant, the employee will profit from the equity upside arising from the grant of such option to the point of exercise. Where the option has a nominal exercise price, the employee effectively benefits from the value created in the company since it was founded, being before such employee joined, or was granted the option.

A nominal value exercise price will make the option more attractive to the employee. If the start-up needs to incentivise talent through a more attractive remuneration package, it would want to grant options with an exercise price of a nominal value. The downside to a nominal exercise price will be the costs of dilution and the much lower cash proceeds a start-up would raise as a result of the exercise of such options. However, the authors are of the view that the ESOP’s first order purpose is to incentivise employees and attract talent, rather than to raise working capital. In the case of a liquidity event, typically a trade sale or an initial public offering, the employees will enjoy the equity upside on the exercised options.

The vesting period sets out how long it takes for the options granted to be allocated to an employee. This is typically over three to four years, after a ‘cliff’ period of one year, where the employee needs to remain employed before any option allocation occurs. This process protects the company as it mitigates the risk that the employee will leave with an equity ownership that is not commensurate to the amount of time and effort he has invested in the company, by staging the grant of the option and incentivises the employee on a continuing basis over the vesting period. The cliff period also allows the company to evaluate the employee’s performance over a period of time before the grant of any options.

The underlying shares

Once exercised, the options will result in employees owning shares as long as the exercise price is paid. There are variants in market practice as to the type of shares employees are issued and allotted pursuant to exercise of their options. Frequently, these would be ordinary shares. However, investors and management founders may not want to have to deal with rank and file employees exercising voting rights as shareholders. To address this, the ESOS rules may provide that the employees, by accepting any ordinary shares issued to them, agree not to exercise their voting rights. Alternatively, we have also seen documentation where a separate class of shares without voting rights are created. Such shares typically would not enjoy any liquidation preference over ordinary shares but will be treated as a single class with the ordinary shares in terms of liquidation preference.

What happens to leavers?

Generally, where an employee resigns during the cliff period, they should not receive any options. Where the employee resigns during the vesting period, they will be entitled to the number of options that have vested. Accordingly, all unvested options will be forfeited. There is usually also a term during which any vested option may be exercised, typically 10 years from the date of grant. If an employee leaves the company, even after all the options granted have vested in full and notwithstanding the term for exercise not having expired, the ESOS rules should either provide for the options to immediately lapse or to lapse after a short period of time following their departure. The purpose of this is to remove any overhang on the capital structure of the start-up caused by an accumulation of such vested but unexercised options.

The ESOS rules should also stipulate reverse vesting rights over the shares acquired through the exercise of options (along with the existing shares owned by the management shareholders) upon any employee leaving the company. The purpose of this to ensure that employees, especially senior or management shareholders who leave do not continue to enjoy substantial voting rights over a start up that they are no longer managing or leading.

Aligned employee behaviour can be encouraged through a pricing mechanism for such reverse vesting - the price of such purchase can be based on a formula that differs depending on whether the employee is a ‘good’ or ‘bad’ leaver, that is, whether such employee is resigning and/or leaving the company on good terms, or being terminated for cause. In the case of a ‘bad’ leaver, the shares of such employees should be able to be vest in the company and/or the founders at nominal value and in the case of a ’good’ leaver, the shares of such employees can be vested back in the company and/or the founders at the fair market value. Another alternative which is used as a negotiated settlement is for employees leaving as a ‘good’ leaver to retain their shares but to surrender the voting rights attached to such shares.

Due to statutory limitations on capital reductions and share buybacks, the company should also consider stating in the ESOS rules that where the full extent of the reverse vesting is unable to take place, that these shares be subject to a right of first refusal process pursuant to which other shareholders can so purchase such shares.

The Big Event – IPOs and Trade Sales

The significant milestone for a start-up would be a liquidity event, typically a trade sale or an initial public offering. The ESOS rules would need to set out what happens then with vested and unvested options.

In order to provide certainty to the acquirer or the shareholding structure of a company on an IPO, vested options are usually to be exercised upon the occurrence of a liquidity event, or within a certain period from such occurrence. For unvested options, these unvested Options should expire upon such a liquidity event or be immediately accelerated and vested. In most cases, the acquirer may choose to retain certain employees and make others redundant upon the acquisition. The ESOS rules should also be flexible enough for the acquirer to permit a rollover of the options whether or not vested. For the roles which may become redundant in a merger, the options will vest immediately.

An additional consideration that companies may wish to note is that in the event of a sale of the company by the founders, to ensure that the minority employee shareholders are unable to block such exit, it may be prudent for the ESOS rules to build in a drag along right for the selling majority shareholder/founder over the shares held by employees arising from any exercise of the options upon a liquidity event.

Other considerations

Administration and filings

When setting up the ESOS, companies will face administrative matters, as well as fillings with authorities such as the registration of the shares in the names of the employees. Depending on the number of employees, this may be a burdensome administrative exercise. Alternatively, instead of having employees hold shares in their name, it may be worthwhile to have a holding company, nominee or trustee, to hold such shares on behalf of employees.

Tax

The gains from ESOS will generally be taxable. The tax implications on employees with different jurisdictions will differ and should considered. Where there are employees in multiple jurisdictions, the company should also seek advice on any applicable securities laws. For instance, directors who are granted options may have disclosure obligations. The ESOS adopted may also need to have certain restrictions, such as on employee’s right of resale, in order to comply with exemptions for the need to issue a prospectus for the grant of such options as an offer of securities. Where the number of options is adjusted, such as in the event of future fund raising by the company, care should also be taken to ensure that no securities laws in any jurisdiction may be breached, and it may be prudent to ensure that the rules of the ESOS dealing with such events are compliant in the relevant jurisdictions from the outset.

As a key takeaway, it is worthwhile thinking early on about an ESOS that will fit into the start-up’s plans towards expansion. This encourages founders to think about the long-term equity structure of the company and will also facilitate fundraising when investors see a robust and considered plan in place.

This article is produced by our Singapore office, Bird & Bird ATMD LLP, and does not constitute legal advice. It is intended to provide general information only. Please contact our lawyers if you have any specific queries.