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.

Definition

ESOP, also known as share based compensation, involves employees receiving portion of their pay in company shares or related instruments. Some plans also directly tie cash payments to the company’s equity value. The main objective is to align employees’ interests with shareholders by connecting compensation to the company’s financial performance. While share based compensation is the formal term, the generic term used for any share based compensation program is ESOP.

Alignment of interests is a fundamental principle that underlies the design and purpose of ESOP. 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. Here are some key aspects and benefits of alignment of interests:

Shared Ownership through ESOP

Share based compensation enables employees to become partial owners of the company through the allocation of stock options or shares. This ownership creates a sense of shared responsibility and commitment to the company’s success.

Financial Stake

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

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 employee stock option plans 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.

Overall, the characteristic of alignment of interests within share-based compensation is a powerful motivator and engagement tool. It creates a win-win situation where employees benefit from company’s success, and the company benefits from committed and dedicated workforce.

Alignment of interest

ESOP vs. VSOP

ESOP (Employee Stock Option Plan) and VSOP (Virtual Stock Option Plan) both represent types of employee compensation plans, but they differ significantly..

Ownership of Shares

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 options and buy shares to attain shareholder status. VSOP does not demand that employees exercise options or buy shares; instead, they receive cash-based benefits.

These differences affect how employees engage in these plans and the structure of their compensation. Companies make a choice between the programs based on their compensation goals and strategies.

To access more detailed information about VSOP, please visit our separate website within our knowledge center.

The ESOP specifies the number of stock options or more generally 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 options/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 grants

ESOP grant document

Exercise price and exercise period

Exercise price

An ESOP sets the exercise price (also known as the strike price) at which employees can buy company shares when they exercise their options. 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.

Each option grant comes with an expiration date, after which the options become worthless if not exercised. This date is set in the program and typically ranges from a few years to a decade or more after the grant date.

Expiration date

Vesting

ESOP vesting development

Vesting refers to the process by which employees gain ownership rights to the stock options 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 stock options or have full ownership of the shares.

Here’s how vesting typically works:

ESOP Vesting Schedule

Every program will have a vesting schedule that outlines the timeline over which employees become eligible to exercise their stock options 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 stock 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. The percentage vested increases each month or year thereafter.

Cliff Vesting within ESOP

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.

Fully Vested

Once employees have completed the vesting period or reached the end of the vesting schedule, they are considered fully vested. This means they have earned the right to exercise their stock options or own the shares outright, and the company has no further restrictions on their ownership.

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 that becomes increasingly accessible over time. If an employee leaves the company before fully vesting, they may forfeit their unvested stock options or shares, which can be retained by the company or returned to the share pool for future use.

For a detailed description of the concept of vesting under IFRS 2, please visit the corresponding website within the knowledge center.

In the context of ESOP, “leaver provisions” are clauses specifying what happens to an employee’s stock options or shares when they leave the company. Leaver provisions are important because they define how stock options or shares are treated in various scenarios of employee departure. Such senarios are resignation, termination, retirement, or other forms of separation from the company.

These provisions can vary significantly from one plan to another, and the plan document or grant agreements typically outline them. Here are common types of leaver provisions:

Good Leaver vs. Bad Leaver in ESOP

Good Leaver typically includes scenarios where an employee leaves the company 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 stock options or shares.
Bad Leaver often covers scenarios where an employee’s departure is considered unfavorable or involuntary, such as termination for cause, resignation without notice, or competing with the company. In these cases, the plan may stipulate that the employee forfeits some or all of their unvested or vested stock options or shares.

Treatment of Vested and Unvested intruments in ESOP

The leaver provisions specify if vested and unvested stock options or 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

Some plans have provisions that permit the company or other shareholders to repurchase the employee’s stock options or shares at a predetermined price when they leave. This can provide liquidity to the departing employee and help the company maintain control of its ownership structure.

Summary

Such provisions are designed to handle the various circumstances that can occur when employees leave the company, ensuring fair and consistent treatment of stock options or shares in line with the objectives of the plan and the company’s policies. It’s essential for employees to review and understand the leaver provisions in their agreements to be aware of the potential outcomes when they decide to leave the company.

Leaver

ESOP leaver

Employee eligibility

The plan specifies which employees are eligible to participate. This can include full-time employees, part-time employees, executives, and sometimes even contractors, although eligibility criteria can vary.

ESOPs often include restrictions on the transfer or sale of options to third parties. This helps maintain the alignment of employee interests with the company’s objectives.

Transfer restriction

Clawback provisions

Some ESOPs include clawback provisions allowing the company to recover gains from exercised options under certain circumstances. Such circumstances are financial restatements due to misconduct and similar issues.

For further information about ESOP, please visit the ESOP association website.