How do Employee Share Ownership Plans (ESOP) work?

Employee Share Ownership Plans (ESOP) involve offering shares of your company to employees. This is a way of attracting and retaining the best employees for your business and motivating them to do their best work.  

Sean Wallace, from Wallace Corporate Counsel, explains when and why you should consider an ESOP and how to implement an ESOP in your business. in this blog, we discuss the different types of plans and structural issues around setting up an ESOP in your company.

This article is based on one of our free #BusinessGrowth webinars. Visit our events page for a list of our upcoming events, which focus on helping you manage and grow your business.

Why should you start an Employee Share Ownership Plan (ESOP)?

  • Recruitment tool

    These programmes can act as a great recruitment tool for employees. ESOP is growing in popularity across industries and some employees are beginning to consider them a must-have.

  • Cost-efficient reward option

    As a Startup, you might not have the budget to offer high salaries in order to attract talent. Offering equity is an alternative method of reward, which can offset a lower salary.

  • A sense of ownership

    Using equity as a reward can help give employees a sense of ownership over the business. The goal is to make employees feel involved with the business and instil a sense of company pride. When employees share in the rewards of company success, such as profits, they may become more aligned with the company goals and be more motivated to perform their roles as best they can.

  • Incentivisation and exit rewards

    Equity is a long-term reward for employees which encourages them to think about exiting a share plan. This occurs when shares are ultimately sold and employees are financially rewarded. This helps employees focus on maximising the value of the shares so that they get the biggest benefit possible upon exit of the plan.

  • Retention tool

    Equity reward schemes benefit employees on an ongoing basis. Rewards can be small to start and increased annually. This helps employees focus on the long-term and motivates them to drive the business forward.

Shares versus Share Options

Before we look further into offering equity as an incentive, Sean outlines that it is important to note the difference between shares and share options.

By giving your employees shares you make them a shareholder in your business straight away. They will be listed on the share register of your company, which is available to the public. Share options, on the other hand, give employees the opportunity to buy shares in the company later, usually at a favourable price. There is no need to publicly share information on share options, so you can keep the rewards you offer to your employees confidential. 

When should you use this type of incentive?

Sean says that it’s important to think about what stage your business is at when considering offering equity as a reward. Remember that your company will go through a life cycle of funding for which you’ll likely have to offer equity. Owners need to consider how much they’re willing to give away. 

Equity rewards are a good option to consider early in the business, in the first 12 to 18 months, when you may not have the funds to offer high salaries. This can help attract and reward early staff to take a risk working for a Startup. It’s also a good alternative to profit-sharing since your company may not make a profit in its early days.  

You need to consider the cost of putting a plan like this into place. Remember that the early stages of a business can be an expensive time. However, as your company grows, so too do the tax implications. The later you leave it the harder it is to make offering shares tax efficient for employees. 

Employee considerations

Equity rewards / ESOPs are long-term rewards that help businesses retain their best employees. You should aim to run these kinds of programmes over 3 or 4 years, with employees earning more shares and a higher reward the longer they stay with the company.

This will incentivise employees not to leave the programme early.  

What happens if an employee leaves?

The structure of these schemes usually means that employees who leave the scheme before its end date of 3 to 4 years won’t continue to benefit. This is because having ex-employees own shares of your business lowers the amount of control you have. Similarly, when a company is being sold, 100% of the shareholders and option holders must agree. Having shareholders who are no longer involved in the business can complicate the process.  

One option to prevent these kinds of complications is to agree on a plan for employees leaving the company early. For example, if an employee left the company two years into the scheme, their shares would be held by the company on their behalf. They would get economic benefits going forward but wouldn’t have a vote in how the company is run. Another option is to have a probation period for new employees before offering equity rewards. 

Which employees should get shares?

You should aim to reward all your staff for their performance but you want to focus on key employees who will drive the business forward. Equity allows you to reward everyone in the company, with some key employees getting greater benefits than others. 

You might also choose to reward external parties to your business, such as consultants. Shares can be a good reward option for people who aren’t on your regular payroll. 

If you have an international business, you’ll still want to reward all employees. However, you should be aware of the impact of the tax residency of your employees. For example, the tax treatments for share options in the US will be different than in Ireland. You need to question whether share options will benefit an employee, considering their tax responsibilities.  

One option for employees overseas is to pay the amount they would benefit from having shares as a bonus, without giving them the shares. However, Sean recommends implementing a share scheme for your Irish employees to start, for simplicity. 

How many shares should you allocate for employees?

The decision on how many shares to allocate to an ESOP depends on how much founders are willing to give away. You’ll need to consider that third-party investors can dilute your company by around 20% over its lifetime. Employee Equity schemes will dilute your control further. 

However, remember that investors will want your company to have the best employees. Many will insist that you have a “pool” of shares set aside to reward employees before they invest. However, they won’t want this pool to dilute their shares. For example, an investor may offer to buy 20% equity of your business, on the condition that you have a 10% pool set aside to reward employees. This means you will have to cede 30% of your business for the investment. 

Wallace Corporate Counsel suggests a pool size of 8-10% for non-tech companies and 12-15% for tech companies. Remember that this is a 3-to-4-year process so you’ll need to budget the number of shares you give away. Consider the need to hire key employees, such as a CFO or CEO. You might need to offer these kinds of employees 2-5% in shares each, which will have a huge impact.  

Other considerations

  • Founders are usually responsible for providing the original pool of equity for employees. However, this pool may need to be topped up in the future. The responsibility for topping up this fund should be shared by the founders and third-party investors.
  • The valuation of your business plays a big part in how much equity you should give employees as a reward. For example, 10% of shares in a company valued at €500,000 is worth the same to an employee as a 5% share in a business valued at €1 million.
  • Details about equity rewards should be closely guarded. Information on employee share options should be treated like salary information and shouldn’t be available to everyone.

Structuring Issues

There are several structuring issues that need to be considered when setting up an ESOP.

For example: 

  • If you have a holding company AND a trading company, the equity should be offered at the holding level. 
  • Consider whether you want to reward employees with shares or share options. Remember, if you give employees shares, they are immediately shareholders in the business. On the other hand, share options give employees the opportunity to buy shares at a favourable price in the future. 
  • If an employee gets €10,000 worth of shares, it is considered part of their compensation package and they will pay tax on it. If they receive the same amount in share options, they won’t have to pay tax. 
  • However, when a company is sold, shares sold will incur Capital Gains Tax (CGT) at 33%, while options exercised at the point of sale can incur Income Tax at up to 52%. Talk to your accountant or advisor for more advice. 
  • The stage your business is at will impact which option you choose. Shares are a better option early on, while share options may be better at a later stage when your business valuation and tax implications are higher. 
  • Consider the impact ESOPs will have on your control of the business. You might consider setting up a nominee structure, which holds shares on behalf of employees. Alternatively, you can create a class of non-voting shares to give employees. In both cases, they will benefit economically but have no say in how the company is run. 

Types of ESOP

Revenue Approved
These are plans with several conditions, set by Revenue. They are more suited to long-standing, traditional businesses and don’t often work for new, high-growth businesses. Time-consuming and costly to put in place and employee participation tends to be low.
Revenue Compliant
Examples include the KEEP scheme. There is no approval process from Revenue required for these kinds of plans. Instead, Revenue provides a set of guidelines that, when met, ensure employees get a specific tax outcome.
Unapproved
This simply refers to any other plan which is not vetted by Revenue.

Plan structuring - Types of ESOP

The most common type of ESOP structures are:

Unapproved / “Vanilla”

This is a basic structure, which acts as a common set of rules for all employees. It lays out how options work; how are they to be exercised and how they lapse when employees leave the company or pass away. It describes what will happen if the company is sold or restructured or becomes insolvent and various other scenarios that may occur. 

This is usually a straightforward plan for all employees. The options offered usually have to be exercised within a defined period (typically less than 7 years). For plans longer than this, options will incur Income Tax at the start. This would mean employees would have to pay tax before they get value, which should always be avoided.  

Key Employee Engagement Programme (KEEP)

The KEEP scheme was introduced by Revenue. It attempts to change the tax outcome when a business is sold. 

Normally, if you have unapproved share options when a business is sold, you exercise your shares, get sale proceeds, pay an exercise fee, and then pay income tax on the balance. The rate of tax paid in this case is very high. With KEEP, the same options get taxed using Capital Gains Tax (CGT) at 33%. Because KEEP is a Revenue scheme, there are several conditions that must be met for businesses and employees to take part. 

Conditions for KEEP

  • Company conditions

    Companies using KEEP must be incorporated in and carrying out a qualifying trade in Ireland. Certain categories, such as financial services do not qualify. You cannot issue share options with a market value over €3 million. Finally, you are required to make annual filings under KEEP.

  • Employee conditions

    Employees benefitting must be full-time and working at least 30 hours a week. Employment must be capable of lasting at least 12 months after shares or options are granted. Finally, the Target Market Value of options must not exceed €100,000 in one tax year or €300,000 in all years of assessment or 100% of the employee’s annual pay in the year the option is granted.

  • Share conditions

    Shares have to be ordinary or non-voting ordinary shares. They can’t be granted at less than the Market Value at the time of issue. Market value is the price shares would reasonably achieve on the open market. Finally, a written contract detailing the number, description, option price, and exercise period is required.

Restricted Share Plan

This is useful when a company has grown in value but needs to offer shares to hire a key employee. The company can put restrictions on the share options they offer.

For example, you might not be able to sell restricted shares for a “hold” period. These restrictions depress the value of the shares so employees will pay less for them. Then, when the shares are sold, they will be taxed using Capital Gains Tax rather than Income Tax.

Growth-Share Plan

This is another useful plan for companies that have grown in value but need to hire key employees. Companies can create a class of shares that have little or no value until the business reaches a certain goal. For example, you can offer your employees shares that aren’t worth anything until revenue reaches €5 million. This might be a good option to offer late joiners to the business. They will only pay a small amount for the shares but they will be motivated to participate in growth.  

With this kind of plan, you must re-evaluate the business every time you issue shares, for example annually. It’s suggested that you get an external valuation from an accountant or auditor the first time. Subsequently, you should choose a metric and apply it every time you re-evaluate. For example, your valuation could be calculated as 7 or 8 times your revenue for the year. 

Tax treatments

How shares and options are taxed is a very important consideration for employees being rewarded this way.  

Typically, for option plans, no Income Tax is paid when they are granted. However, it is paid when the options are exercised, on the difference between the exercise price and market value.  

KEEP plans are different in that they allow participants to be taxed using Capital Gains Tax instead of Income Tax. 

In a Restricted Share Plan, participants qualify for a lower Income tax liability because of the restrictions on the shares. This tax relief does not apply if the restrictions aren’t adhered to, for example, if they are sold before the end of the hold period. On exit of the plan, shares will be taxed using Capital Gains tax. 

Finally, for Growth Share Plans, there is no initial Income tax liability and shares are taxed using Capital Gains tax on exit. 

Implementation

The amount of documentation you will need depends on the type of plan you choose. However, in most cases, you’ll have to adjust the company constitution to create different share classes and detail how shares are to be issued and what happens when they’re sold.

Costs for implementing share plans vary depending on the type of plan. However, Wallace Corporate Counsel suggests budgeting €2500 to €3000 for the implementation.

Key takeaway

Employee Share Option Plans (ESOP) are a great way to align key employees with the goals of your company. They can help you attract and retain key talent and motivate them to do their best work. They are an attractive option for companies that haven’t been in business for long. Share options can help make up for a lower salary and encourage key employees to join your Startup in its early days. However, remember that as your company grows, the complexity of these schemes will grow. Therefore, they might not be a good option for an established company. In these cases, performance-related bonuses may be a better alternative. 

more information

#BusinessGrowth webinar series

The information for this blog came from one of our free #Business Growth webinars. To make sure you don’t miss our next webinar, see a full list of our upcoming events to learn more about funding for our business, HR supports, grants, pensions, Research and Development tax breaks, employee benefit incentives, Xero accounting software, and much more.

You may also be interested in