The growing trend for employees to participate in the company’s success through ESOP makes it essential for both employees and the company to better understand the basic principles of this form of remuneration.
Dominik Konold CEO/founder of Findiy GmbH, specializes in banking and corporate finance. With a background in audit and investment banking, he's a certified Professional Risk Manager and also serves as a lecturer in banking and accounting.
ESOP Definition
Alignment of interest within employee stock ownership plan
Alignment of interests is a fundamental principle that underlies the design and purpose of such a plan. It refers to the idea
that by providing employees with a direct stake in the company’s ownership and financial performance. Their interests
become closely tied to those of the shareholders and the company as a whole.
More than tax benefit: Shared Ownership through ESOP
Share based compensation enables employees to become partial owners of the company through the allocation of stocks or shares. This ownership creates a sense of shared responsibility and commitment to the company’s success with certain tax advantage.
Financial Stake in ESOP companies
When employees have a financial stake in the company, their personal financial well-being is directly linked to the
company’s performance. As a result, they have a strong incentive to work collaboratively and diligently to contribute to
the company’s growth and profitability.
Long-Term Perspective of ESOP
Employees with such program benefits are often more likely to take a long-term perspective on their work and the
company’s objectives. Beneficiaries are less focused on short-term gains and are more invested in the company’s
sustainable success over time.
Motivation and Engagement
Knowing that their efforts can lead to increased stock value or financial rewards, employees are more motivated,
engaged, and proactive. They are more likely to go the extra mile to achieve the company’s goals.
Employee Loyalty beyond retirement plan
The alignment of interests cultivates a strong sense of loyalty among employees. Beneficiaries feel a sense of ownership
and pride in their contributions to the company’s growth and success.
Ownership Mentality through ESOP
Employees with such a plan often develop an “ownership mentality.” They act as if they were true owners of the business, taking initiative, making thoughtful decisions, and treating company resources with care. It creates a win-win situation where employees benefit from company’s success, and the company benefits from committed and dedicated workforce.
ESOP vs. VSOP and other employee benefit plans
ESOP and VSOP (Virtual Stock Option Plan) both represent types of employee compensation
plans, but they differ significantly. An ESOP is more cash-efficient than a VSOP and helps free up funds to repay the loan. Both types of share-based compensation are tax-deductible in most juristictions.
Ownership of Shares boosting corporate performance
Share based compensation allows employees to become actual shareholders by buying company stock at a predetermined
price. Virtual plans do not give employees ownership of company shares; instead, they receive cash-based benefits linked
to stock value without owning shares.
Value Realization
The value directly depends on the company’s stock market performance, enabling employees to benefit from increases in
stock price. VSOP’s value originates from virtual units or phantom stock and offers cash-based benefits associated with
stock value.
Exercise and Purchase
In share based compensation, employees must exercise their rights and buy shares to attain shareholder status. VSOP does not demand that employees exercise or buy shares; instead, they receive cash-based benefits. These differences affect how employees engage in these plans and the structure of their compensation. To access more detailed information about VSOP, please visit our other article within our knowledge center.
ESOP grants
The plan specifies the number of instruments granted to eligible employees. Employees
have the right to purchase company shares at a predetermined exercise price or receive a corresponding cash payment for
these granted instruments.
ESOP Grant Agreement
Employees typically receive a grant agreement that outlines the terms and conditions of their plans in particular specifying the type instruments granted. This document includes essential information such as number of instruments, exercise price, vesting schedule, and any restrictions or conditions.
ESOP Exercise price and exercise period
Exercise price
An ESOP may set the exercise price (also known as the strike price) at which employees can buy company shares when they
exercise their grants. This price is typically set at or above the current market price of the company’s stock on the
date of grant.
Exercise period
The plan outlines the period during which employees can exercise their options. This period often extends beyond the vesting period to give employees flexibility in choosing when to exercise.
Expiration date
Vesting in ESOPs
Vesting refers to the process by which employees gain ownership rights to the stocks or shares granted to them
through the plan. It refers to a schedule that specifies the period over which employees must work for the company
before they are entitled to exercise their grants or have full ownership of the shares.
How vesting of ESOP works
Every program will have a vesting schedule that outlines the timeline over which employees become eligible to exercise
their grants or gain ownership of the shares. These schedules can vary but often follow a gradual approach, with
employees becoming partially vested over time.
Vesting Period
The vesting period is the duration during which employees must remain with the company to earn the right to exercise
their options or own the shares. For example, a common vesting schedule might be a four-year period with a
one-year cliff. It means that employees are fully vested in their options or shares after four years of employment, but
they become partially vested after just one year.
Cliff Vesting within ESOPs
Some plans include a cliff vesting period, during which employees do not vest at all until a specific period, usually
one year, has elapsed. After the cliff, employees typically vest on a more gradual schedule.
Summary
Concept of vesting is important for share based compensation as it aligns employee retention with a company’s goals. It encourages employees to stay with the company and contribute to its growth by offering a valuable benefit and capital gain that becomes increasingly accessible over time. For a detailed description of the concept of vesting under IFRS 2, please visit the corresponding article within the knowledge center.
Employee ownership and Leaver
In the context of share-based payment, “leaver provisions” are clauses specifying what happens to an employee’s grant
when they leave the company. Leaver provisions are important because they define how share are treated
in various scenarios of employee departure. Such scenarios are resignation, termination, retirement, or other forms of
separation from the company.
Here are common types of leaver provisions:
Good Leaver vs. Bad Leaver in ESOPs
Good Leaver typically includes scenarios where an employee resigns due to reasons deemed favorable by the
plan. Examples of good leavers may include retirement, disability, or resignation for personal reasons. Within the good
leaver case the employee may be allowed to retain their vested grants.
Bad Leaver cover scenarios where an employee’s departure is considered unfavorable or involuntary, such as
termination for cause, resignation without notice, or competing with the company.
Treatment of Vested and Unvested instruments in ESOP
The leaver provisions specify if vested and unvested shares receive different treatment. For example,
the plan might allow employees to retain vested options or shares upon good leaver status but forfeit unvested ones.
Buyback or Repurchase Rights within ESOP companies
Some plans have provisions that permit the company or other shareholders to repurchase the employee’s shares at a predetermined price when they leave. This can help the company maintain control of its ownership structure.
Summary: Not just a retirement plan
Such provisions are designed to handle the various circumstances that can occur when employees quit, ensuring fair and consistent treatment of shares in line with the objectives of the plan and the company’s policies.