The merits of an ESS are very well-accepted within the business sector, given attracting, retaining, and incentivizing key talents’ critical importance to the success of any startup. In fact, the setting aside of up to 15% of startups’ and scale-ups’ cap table for employee share ownership has become almost obligatory. Investors will often ask why if it isn’t done. Some will even list an employee share scheme’s creation as a condition before they invest.
Companies, however, often run into challenges or mistakes, limiting the scheme’s effectiveness at best, and even creating a tax, legal, and administrative mess at worst. To help you make the most out of an ESS, here are the factors that you should know about it when planning to set up one.
As a company, you can choose to give employees actual shares now or another option that can be exercised in the future. These are the two types of shares:
- Ordinary Shares – These are real shares in your business that you can give to anyone. Ordinary shares are the ones that business owners and investors alike will hold.
- Growth Shares – These function like ordinary shares, although they’re issued at a price that’s representing a small premium to your company’s value at that time, which is known as the ‘hurdle price.’ The price is often around ten to 40% to reflect the shares’ ‘hope value.’ As such, the recipient will only be sharing in the growth in the value of your business from that point on.
An employer will offer employees options to purchase shares in their company under an employee share scheme’s term. What’s an option? It’s essential to note that it isn’t an obligation, but, rather, a right to buy shares in a company. Another important thing to remember about an option is that it will delay a share’s creation until a future date.
Vesting refers to the period of time after which an employee can act on their shares and even sell them. Options vest is, generally, based on an employee’s length of service to your company; between three to five years is the standard time frame. Options vesting happen at various intervals within this duration. Below is an example calculation:
If the shares that your company offers vest at 25% for every year that an employee is officially working for you, the employee will be able to put up 100% of their shares for sale after four years. After a year, that’s 25%, 50% after two years, then, 75% after three years, which becomes 100% after four years.
Once all options have vested only then an employee can exercise their options. That means the options will lapse if the employee chooses to leave your company before all options have vested.
4. Exercise Price
For the option to be exercised by the employee, they must pay a certain price. The price will be set out by the employee share scheme documents. It’s called the exercise price.
The exercise price has to be at least a share’s fair market value in the company if the employee wants to benefit from tax concessions. Note that the price that will be considered is the price on the date the company granted the option. Either of the two methodologies for safe harbor valuation can be used by you as a business owner to calculate the fair market value.
For employees, purchasing shares is risky. They’d hope that as your company grows, the shares’ value will grow, too. Employees retain the option to purchase shares at the exercise price, hoping that it will be far less when compared to the current market value. If that’s the case, then, the employee is likely to make a profit when they decide to sell.
It’s essential to note, however, that while employees have options, they don’t have the right to dividends or voting rights.
To benefit from the startup tax concessions, the employee needs to hold the shares or options for a minimum of three years. That’s unless the employee leaves your company or in case of other limited circumstances. Unless there’s an exit event, however, employees won’t usually dispose of their options or shares.
Employees will need to do either of the following when they exercise their options and buy shares:
- Sign to show agreement to a deed of accession and be bound by the shareholders’ agreement’s terms
- Enter into a shareholders’ agreement
The shareholder agreement is going to govern any shares disposal once employees already become shareholders.
Hopefully, the discussion in this post can help you decide whether or not setting up an ESS is right for you. It should also help you understand how to set it up properly if ever you want one in your company to help improve employee performance.
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