Under an ESOP a business will create an 'option pool' where it sets aside options that can be allocated to employees. The standard option pool size will vary between 5% and 15% of the fully diluted capital in the Company, but it can vary. Companies will typically work with their lawyers to create:
- ESOP deed containing the core rules for the ESOP
- Offer letters for employees containing vesting rules
- Potentially a Director's Deed authorising the ESOP creation and offers
During the setup phase the business, often in conjunction with the employees need to confirm:
- The amount of options being issued
- The exercise price
- The vesting period
- The expiry date
- What happens if an employee leaves
- What happens in a liquidity/sale event
Once all information is confirmed it can be entered into Orchestra so all stakeholders can be made fully aware of all relevant details and conditions.
It is important to also note that an ESOP will create obligations for a company, once created. A company will be obliged to sell those shares to the employee if the criteria are met. But there are also compliance matters, such as providing a valuation when shares are exercised, certain director resolutions, and communications with current investors.
Under an ESOP, an employee is not able to 'exercise' the option, until that option 'vests'. This means that the option cannot be converted into a share, until the option has vested.
Vesting normally takes the form of:
- Automatic time-based vesting and/or
- Manual/Performance-based vesting
Automatic/ Time-based Vesting
Automatic or time-based vesting can either occur by way of a Periodic Vesting, the use of a cliff or both. Orchestra can facilitate the easy understanding of these methods.
- Under a Cliff, a certain amount of options vest after an initial period has passed. For example, 6 months worth of options will only vest 6 months from the start of the ESOP grant
- Under Periodic vesting, the options vest gradually over a period of time (generally monthly, quarterly or yearly).
Options will vest on the achievement of some defined milestone or performance hurdle. If the options don't vest (for example, because the milestone is never achieved), they lapse. This means they can no longer be vested or exercised by that employee. They can then be recycled back into the option pool, where they can be allocated for other employees or other offers.
Vested options can be exercised then purchased by the employee at the price agreed in the offer documents. Orchestra can easily facilitate the transfer of options into ordinary shares in your official cap table.
Once an employee exercises options they become a shareholder in the business and are entitled to the same rights as other shareholders.
Tax considerations when exercising shares
The granting of a share option is not a taxable event. However, taxable income may be created for the option holder when options are exercised.
The amount of taxable income is the difference between the exercise price and the market price at the time shares are purchased. For example, if an employee exercises 1,000 options with an exercise price of $1.00, and at that time the shares are worth $2.00, this has created a taxable income for the option holder of $1,000 (1,000 x $2.00 – 1,000 x $1.00).
The business is entitled to a deductible expense equal to the employee income and must disclose this in PAYE returns. However, paying a PAYE on behalf of employees is optional. If the PAYE is not paid on behalf of the employee, the employee will need to pay this tax directly to the IRD.
It is possible to construct a cashless exercise with employees selling back some shares to pay for the tax and exercise price, and/or cash bonuses to be paid to cover short-falls.
If share options expire without employees exercising they can then be recycled back into the option pool, where they can be allocated for other employees or other offers.
5. Liquidity Event - What happens in a company exit?
Your initial ESOP deed will contain information relating to what happens in a liquidity event for your business, including whether unvested options automatically vest or expire.
Contact us if you would like to learn more about ESOPs.