An employee share option plan (ESOP) is a scheme that you can implement to offer employees, contractors and advisors an interest in your company in return for the services that they provide to you. Under an ESOP, service providers are offered options in your company. Options give the holder the right to acquire shares in your company at a later time (usually, when an exit event takes place). This article sets out some practical tips to consider when implementing and administering your ESOP.
Implementing Your ESOP and Issuing Options
Some matters that you need to consider when you are setting up an ESOP and issue options are:
- Whether you will need to provide a disclosure document to employees: the general rule is that a disclosure document is required for the issue of options unless an exemption applies. Most startups rely on rules which provide them relief from the obligation to provide a disclosure document, including exemptions such as:
- the small scale offering exemption;
- the senior management exemption; and
- professional/sophisticated investor exemptions.
- The tax treatment of the ESOP: tax concessions are available in Australia for ESOPs that meet certain requirements. If you are seeking to rely on startup tax incentives, you may need to structure your ESOP to ensure that it meets the criteria for those incentives.
- How many options you will issue to each team member: this is ultimately a matter for you to decide but some factors to take into account are:
- the total size of the ESOP pool;
- the service provider's role; and
- how long the service provider has been/will be with the company.
It is common for early employees to receive more options than employees that join the company later.
Record Keeping
It is important to manage your ESOP well. As a starting point, you are legally required to maintain an options register containing the following information about each option holder:
- full name;
- residential address;
- date of entry into the register;
- date of granting the relevant options;
- number and description of shares or interest over which options were granted (e.g. 200 ordinary shares);
- period in which the options may be exercised;
- any conditions to the exercise of the options;
- grant price (often zero); and
- exercise/strike price.
Your company must enter the above information into the options register within 14 days of granting the option.
As well as the above legally required information, you should track when an employee starts and leaves the company (to track the vesting requirements). Likewise, record whether an employee's options have lapsed or vested.
It is important to keep track of the number of options that have been issued and the dates so that you:
- can track the amount of the ESOP pool that has been allocated;
- know how many options each employee has been issued and the terms on which they were issued; and
- comply with the law.
Additionally, you should store all of the ESOP documents (including the plan rules and each employee's offer letter) in a secure place. It is also a legal requirement that people in your company who administer the ESOP can access these files.
If you intend to issue a large number of options to employees, consider if you would benefit from using an online ESOP management platform (e.g. Cake Equity). Such platforms can:
- reduce the administrative burden of managing all of the above information;
- prevent inconsistencies; and
- ensure there is one source of “truth” concerning your ESOP plan.
Reporting Requirements
Proper management of your ESOP is also important for compliance with ESOP reporting requirements. Your reporting requirements will depend on how you structure your ESOP and where you are based.
A common reporting requirement is the ESS statement and the ESS annual report, which you may need to provide to your employees and the ATO. You should speak with your accountant or legal adviser to determine what reporting requirements will apply to your ESOP.
What Happens When Employees Leave?
Options under an ESOP will usually be subject to a vesting period. A common time-based vesting period is four years. An employee is only legally entitled to the options when they vest.
If an employee leaves the company before all their options have vested, the ESOP terms will usually state that the unvested options will lapse (which means the employee is no longer entitled to exercise those options).
Depending on the terms of your ESOP, when an employee leaves the company, they may be:
- required to exercise their vested options (and pay the relevant strike/exercise price);
- required to relinquish their vested options for less than market value if they leave on bad terms (if the terms of your ESOP include bad leaver provisions); or
- entitled to retain their vested options and only exercise them on a liquidity event.
From a company administration perspective, it may be preferable to only allow your employees to exercise their options upon an exit event. This is because if you allow your employees to exercise their options before that time, they will be shareholders, and certain decisions may require their approval. Suppose you draft your ESOP this way (i.e. exercise only on an exit event). In that case, proper ESOP record keeping will be even more important because you will have a larger number of option holders to keep track of (as opposed to shareholders, which you must register with ASIC).
Key Takeaways
You need to stay on top of the administration of your ESOP to ensure that you comply with legal reporting and record-keeping requirements. Although good administrative practices are often not a priority for early-stage companies, ensuring that you comply with best practice record keeping will prevent inconsistencies in your ESOP further down the track when your company is very valuable (which can cost you and your employees a lot of money).
