Employee participation – ESOP Shares, Options, and Administration

Employee stock ownership plans (ESOP) are excellent tools, not only to attract employees but also to motivate them to stay with the company in the long term. If employees become shareholders, they can participate in the company’s success and develop a feeling of ownership.

After looking at the most important clauses of an ESOP and the concept of vesting in the last article, we will now explore why shareholder approval must be obtained (1.1), whether to issue options or shares (1.2) and why it is important to always keep track of the options issued (1.3).

1. Employee Stock Ownership Plan (ESOP) 

Granting shares to employees inevitably leads to a dilution of the existing shareholders. It must therefore always be ensured in advance that the necessary shares are available for the participants via a provision in the shareholders’ agreement or through conditional share capital. When setting up an ESOP, participants can either be issued shares or options to purchase shares at a later date, once the options have vested. Once the first options or shares are issued to participants, proper management and administration of the plan, as well as the cap table and stock ledger, are essential.

1.1 Shareholders’ approval 

Under an ESOP, participating employees will sooner or later become shareholders of the company. To transfer shares to the employees, the shares must either be:

1. ‘reserved’ in advance in the form of conditional share capital so that the options can be easily exercised (conditional capital increase);
2. an ordinary capital increase is required to issue new shares;
3. existing shareholders offer their own shares; or
4. the company already holds treasury shares.

Both the resolution on a conditional capital increase or an ordinary capital increase must be passed by the general meeting of shareholders. Even if the shares are made available by an existing shareholder or the company, shareholders’ agreements usually provide for transfer restrictions (e.g. right of first refusal), which means that shareholder approval must be obtained in this case as well.

We therefore always recommend obtaining the approval of the shareholders in advance. Ideally, consent is obtained in advance via the shareholders’ agreement. To create the shares necessary for the ESOP, the shareholders undertake to either (i) create conditional share capital, (ii) agree to an ordinary capital increase and waive their subscription rights to the extent necessary, or (iii) to approve the transfer of shares of an existing shareholder or of the company to participants. 

1.2 Options vs. Shares

The ESOP can either be structured in such a way that (i) the participants first receive options that vest  which can then be ‘exchanged’ for shares once they have vested, or (ii) shares are transferred directly to the participants.

1.2.1 Options

Options give a participant the right to purchase shares of the company at a later date. As soon as the options have vested, the participant can choose to either exercise the options immediately (and thus become a shareholder) or to wait, e.g., to avoid triggering a tax liability in a specific tax period.

The three key aspects of options are the following:

1. If an employee leaves the company, the unvested options are forfeited and vested options can only be exercised conditionally;
2. the company does not have to account for social security contributions until the options are exercised and there are no tedious claims for reversal if an employee leaves prematurely; and
3. options only become relevant from a tax point of view when they are exercised by the employee.

If a participant leaves the company (e.g. in a dispute), the plan usually provides that the options expire without action by the company. Especially the handling of unvested options in case of termination of employment is easier for the company compared to the direct issuance of shares (although in the case of shares a blank assignment can be obtained in advance).

Early stage start-ups usually do not have the balance sheet requirements to acquire / hold treasury shares (i.e. sufficient free reserves, e.g. retained earnings in the amount of the purchase price). That is why, especially in financing rounds, we see that conditional share capital is created for the ESOP in the course of the associated capital increase.

1.2.2 Shares

If the participating employees receive shares instead of options, they become shareholders at the time of allocation (i.e. with the signing of the declaration of assignment by the transferor). With the transfer of the shares, the exercise price must be paid.

When allocating shares directly, the allocation agreement (aligned with the shareholders’ agreement) should provide for so-called reverse vesting. A reverse vesting clause encourages employees to remain loyal to the company despite the immediate allocation of shares. Market standard is four-year reverse vesting period with a one-year cliff.

Example: An employee who leaves the company before the end of one year after the allocation of shares must return all shares at their nominal value.

• At the end of the year, the employee has vested 25% of the shares.
• The remaining 75% vest over the next three years (linearly on a monthly or quarterly basis).

Thus, if an employee leaves the company two years after the shares have been allocated, she/he must return 50% of his shares at nominal value. He/she can either keep the remaining shares or the allocation agreement can stipulate that they must be returned at market value. 

The following three key aspects need to be considered when issuing shares upfront:

1. To ensure that unvested shares can be easily repossessed if a participant leaves the company, we recommend a blank declaration of assignment;
2. the difference in value between the exercise price and the tax value qualifies as income for the participant; and
3. social security contributions must be paid on the difference between the exercise price and the tax value.

By law, a company may only hold 10% treasury shares (20% if the portion exceeding 10% is sold again within two years) if it has sufficient ‘free reserves’. If these conditions are met, it may be efficient for the company to buy / subscribe for treasury shares for the ESOP or to agree with an existing shareholder on a buy-back of shares to have the shares needed for the ESOP available.

If the shares are issued in advance, employees usually benefit from a lower enterprise value and any lock-up periods for the sale (e.g. unrestricted tax-free capital gains if the shares are held for a period of at least 5 years by the participant) start to run immediately.

1.3 Manage and Administrate Options

After the ESOP based on options is introduced, the first options are soon issued to employees or shares are allocated. In practice, it often happens that options are allocated to different employees at different times (sometimes even with different vesting periods). It is therefore extremely important to keep a good overview, especially of the following points:

• Who received how many options / shares?
• At what point in time were the options allocated?
• Overview of the individual vesting schedules (reverse vesting in case of shares)
• How many options remain in the option pool / how many treasury shares are left?
• Are there options that have expired or are forfeited?
• Where to keep/store the (blank) declarations of assignment?

Once options are vested, they can be exercised by employees. Typically, the ESOP provides that the options can be exercised once a year during an exercise window (e.g. between 1 of May until 30 of June). This makes the administration somewhat easier.

To exercise the vested options, the employee submits a so-called exercise notice to the company. If the company has created conditional share capital for the ESOP, the employee becomes a shareholder immediately upon exercise of the option.

The board of directors has to amend the articles of association once a year within 3 months after the end of the business year, to be executed by the board of directors in front of a notary public. This means that the conditional share capital must be reduced by the amount in which options were exercised and the share capital increased by the corresponding amount. Also, an audit report is required for the adjustment of the articles of association, which confirms that the exercise of the options was correct.

Upon receipt of the exercise notice (and payment of the exercise price, if agreed), the participant becomes a shareholder. The company has to amend the articles of association once a year (at the latest 3 months after the end of the business year). This is to be executed by the board of directors with an audit confirmation in front of a notary public (reduction of the conditional capital in the articles of association and increase of the share capital in the same amount).

For easy management and administration, we recommend the tool from Ledgy. This helps the company to easily keep track of the ESOP or PSOP (and other key performance indicators).