Employee Stock Option Plans (ESOP) in Singapore
ESOPs (Employee Stock Option Plans) are a tool that grants the employees of a company the right to purchase shares of the company.
Startups and growing companies often use ESOPs to compensate or cost-effectively reward their employees.
This blog post will explore what an ESOP is, its benefits, and other vital issues to consider.
What is an ESOP?
An Employee Stock Option Plan/Employee Stock Ownership Plan is a mechanism that grants employees the right to purchase shares of their company.
ESOPs are controlled and issued by the company’s board.
The company will set aside an amount of its total equity to offer as part of the ESOP. This equity will be provided to its employees over time through the ESOP.
The board of management decides the price of the shares being offered as part of the ESOP. The share price will be offered with a significant discount on the fair market value of the shares.
ESOP agreements are made up of 2 distinct periods:
- The ‘vesting period’ is the period it will take for an individual’s shares to be issued to them throughout their employment. Usually, a vesting period will be 3 to 4 years.
- The ‘cliff’ or ‘lock-in’ is the amount of time an employee needs to remain with the company (typically one year) before the ESOP begins and they start to earn their share options.
Why do companies offer ESOPs?
ESOPs are a valuable tool for companies and offer many advantages for both the company and the employees.
ESOPs can form part of a compensation package.
ESOPS are excellent options for companies with limited or small cash flows. Suppose a company is in such a situation and wants to attract new employees or retain the ones they already have. In that case, an ESOP can be a highly attractive tool – especially for startups with high growth potential.
Retention of employees
As mentioned above, ESOPs will typically have cliffs and vesting periods; therefore, an employee who has entered into an ESOP will be more likely and willing to remain with the company until they can exercise their options.
Factors to consider when offering an ESOP
ESOPs offer companies many advantages; however, there are also several important considerations for companies to be aware of.
Setting up an ESOP is not a complex procedure
Setting up an ESOP usually requires the company to amend its constitution and prepare ESOP letters detailing the terms of the program.
Deciding the percentage of the company equity to make up the ESOP
Legally, there is no restriction on the size of equity required to offer as part of an ESOP. However, it is typically recommended that companies limit the equity they wish to provide their employees.
A typical example would be a company setting aside 5-15% of the company’s equity as part of the ESOP. Employees will then be given the right to purchase an equity share of between 0.5% to 3%.
Dilution of the company’s equity
ESOPs result in ownership equity being distributed among many individuals; therefore, the amount of equity held by the founders or owners will be reduced.
In situations like this, clauses such as drag-along rights should be considered. Such clauses enable a specified majority of shareholders to force minority shareholders to sell their shares in certain situations.
What happens if employees leave the company after shares have matured?
As part of the ESOP agreement, a provision should be included that governs what happens when an employee who holds an ESOP leaves the company. Typically, when an employee leaves the company, all of the unvested options will be forfeited. However, they will retain any vested options.
It is common practice for companies to have bad leaver and good leaver clauses in place to deal with the above.
Good leaver/bad leaver clauses
It is good practice for Companies to use leaver clauses to define what will happen to participants of the ESOPs equity when they leave the business. Typically, Good leavers will keep hold of their vested share options after they leave, whereas bad leavers lose their right to retain any equity, even the options that have vested.
Below is a list of the most common examples of good leavers:
- Serious illness or death (in which circumstance the employee’s share options would transfer to the next of kin);
- Being made redundant through no fault of their own, e.g., as a result of a merger or because the role is no longer necessary.
Whereas bad leavers typically include employees who:
- Commit gross misconduct;
- Are convicted of a crime, such as committing fraud or embezzlement;
- Break a noncompete clause or violate the terms of a shareholders’ agreement;
- Voluntarily resign before reaching a particular milestone, e.g., before all their shares have fully vested.
How to structure an ESOP?
When looking to set up an ESOP, the company should consider things such as financial health, needs, and objectives.
Other areas to consider include the following:
- how to reimburse employees,
- how to value the stock options, and;
- how much equity to offer.
Typically, an ESOP should include the following.
The ESOP Agreement and ESOP committee
When creating an ESOP, the company will establish an Employee Stock Option Pool (ESOP Pool). The ESOP pool will comprise a percentage of the company’s equity shareholding, which will be available for their employees.
ESOP Agreements will also establish the details of the members who form the ESOP committee. The ESOP committee consists of the company’s directors and other officers and manages the ESOP Pool.
The Cliff and Vesting period
A Vesting schedule sets out when the employees can claim their shares over time and not all at once.
The vesting ‘cliff’ is when the shares cannot be vested. The ESOP will become fully vested when the specified time (the ‘cliff’) has been met.
If an employee who holds ESOP resigns from their position during the Cliff period, they will not receive any stock options.
The Vest period is different and sets out the period before the employee unconditionally owns shares in an ESOP.
Should an employee resign during the Vest period, they are eligible to receive pro-rated stock options. The amount of stock offered will be based on the length of their employment.
Companies can include selling restrictions as part of the ESOP to protect their equity. These restrictions will be a period during which the employee will not be able to sell their shares.
What are the tax implications of an ESOP?
Under Singapore law, all the gains made from an ESOP are taxable. These earnings will be taxed in Singapore if the employee is a resident of Singapore. Therefore, an employee of a company based in Singapore will be required to pay tax on any earnings derived from an ESOP.
How can Belaws help?
If you have a question about ESOPs in Singapore, speak to one of our experts directly.
You can also view our Singapore incorporation services here.
Please note that this article is for information purposes only and does not constitute legal advice.
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