What is an employee share ownership plan (ESOP)?

An employee share ownership plan (ESOP) is a plan that grants employees an opportunity and cheaper means to become co-owners of the company.

In a typical ESOP, the company would offer selected employees an option to buy shares in the company at a discounted price. The option is usually subject to certain conditions, and the condition can be time based (i.e. vesting / cliff) or performance based.

Vesting

For time-based conditions, it means the option has a vesting schedule. The options would normally vest progressively over a period of time. You can only exercise the options that have been vested. For instance, if a company offers you 10 shares and only 2 shares would vest every year. It would need 5 years to vest the entire 10 shares. If you want to buy the shares in year 2, you can only exercise a total of 4 vested options to buy 4 shares because the remaining 6 options have not been vested yet.

Cliff

Vesting schedules can have a cliff designating a length of time which you must work for the company before the share options would vest at all.

For example, if your share options have a 1-year cliff and you only worked for the company for 7 months, you would not be able to exercise the share options to buy any shares in the company. You would need to complete the 1-year term in the company (i.e. the cliff) before you can exercise the options that have vested in the first year.

Typically, equity plans have a 4-year vesting schedule plan with a 1-year cliff. Of course, this varies based on the actual objectives of the company.

Performance-based conditions

For performance-based conditions, it means you would need to meet certain key performance indicators (KPIs) before a target date before the options would become vested.

In short, the conditions under the grant must be fulfilled before you can exercise the options to buy the offered shares.

Exercise price

Exercise price is the price which you must pay to exercise the options to buy the shares. To motivate and incentivize employees, the exercise price is usually lower than the actual value of the company. The discount rate is usually more than 10%.

Why ESOP

ESOP is an effective means to attract, retain and reward talents. In today’s market, monetary compensation alone often lacks appeal. This could be due to the lack of sense of belonging or ownership in the business.

In the early stage of a business, business founders can use ESOP to complement monetary compensation of key talents to preserve cash for business development.

Further, ESOP typically has a few years term and with the right vesting schedule, the team would be incentivized to stay on for an extended period of time.

Other than being an additional benefit, ESOP aligns the interest of the company and its key talents. With partial ownership, the employees would be motivated to work towards achieving the vision set for the company and create higher shareholders’ value, because they are one themselves.

In the next article – when should you set up an ESOP? – we will explore the timing which business founders should consider setting up an ESOP and why.