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

ESOP, compared to other benefit plan like a retirement plans, 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.

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

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

Each 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.

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.

For further information, please visit the ESOP association website or at the national center for employee ownership.

Share:
Disclaimer: The contents of the information offered at incentrium.com do not constitute legal advice. If you require a legal review of your individual case, please contact a lawyer.