Employee Share Scheme - What you need to Know

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Date published: 4 Jun 2020
by DocPro Legal
Last Update: 16 Jul 2021

Employee Share Schemes are used by businesses as a means of enhancing the motivation of employees and aligning their interests with the firms’. Through an employee share scheme, employers can choose to share ownership or equity of their company with employees. Share schemes are especially popular among start-ups as they are cost-efficient and help motivate/increase the productivity of employees. Through this article, we will discuss everything about employee share options schemes you need to know to implement them. 

 

What is the difference between an Employee Share Scheme and an Employee Option Scheme?

 

There are two ways to give your employees equity: (i) you can give them actual stocks immediately, or (ii) you can issue them stock options that are to be exercised in the future. The key difference between issuing stocks and options are as follow:

 

Stocks

Options

Stocks are issued right away

Options are vested over a period of time

Stockholders are entitled to dividends

Dividends will only be paid after exercise

Stockholders have the right to vote

Option-holders have no voting rights

Stocks once issued cannot be revoked

Options can be revoked until vested

Stocks are issued as compensation

Need to pay a price to exercise the options

Need to pay income and capital gain tax

Taxes will be deferred until after exercise

 

A. What is an Employee Share Scheme?

 

Employee share schemes involve the issue of actual shares right away to the employees as part of compensation. The idea behind employee share schemes is that rather than paying employees fully with cash, compensating employees partly with shares of the company better aligns their interests with business interests.

 

Two common types of stocks issued under an employee share scheme are Ordinary Shares and Growth Shares:

 

1. Ordinary Shares

 

Ordinary shares are actual shares of a company (not options purchased in the future) that can be allocated to anyone. They usually constitute existing shares held by business owners and investors. Some companies conduct shares buyback in advance to be issued to employees. 

 

Ordinary shares are no different from ordinary shares in the market and can be sold immediately after they are granted. Recipients may be liable for income tax for the value of shares granted as well as capital gain tax for any appreciation in value. 

 

2. Growth Shares

 

Growth shares are like ordinary shares but are issued at a "hurdle price" (usually at a 10% to 50% premium to the current market value) to reflect the future value of the stock. Growth shares are therefore better aligned with the long-term interest and trajectory of the company since he/she only shares the growth of the company based on a future increase in value.

 

 

B. What is an Employee Option Scheme?

 

An employee options scheme is a type of contract given by the employer which allows the employee to purchase a certain number of shares of the company’s stock at a fixed price over a specific period.

 

The two common types of schemes are Incentive Stock Options (ISO) and Non-Qualified Stock Options (NSO).

 

1. What is an Incentive Stock Options (ISO) scheme?

 

An incentive stock option (ISO) is a form of compensation that gives employees’ right to buy stocks of the company at a discount. ISOs are issued on the grant date, giving employees the right to exercise their options on the exercise date. Once the option is executed, the employee can choose to sell the stock immediately or wait for some time before selling. 

 

ISOs contain a vesting schedule that employees must meet to exercise options. ISOs can usually be executed at a price lower than the current market price - this enables employees to profit from the sale of shares.

 

2. What is a Non-Qualified Stock Options (NSO) scheme?

 

NSOs are like ISOs, apart from the fact that the stock options do not meet the conditions for employees to enjoy preferential tax treatment. 

 

3. What is the difference between incentive stock options and non-qualified stock options?

 

The main difference between the two is that ISOs are given preferential tax treatment and are offered to a smaller range of people. The issuance of ISOs by the company entitles it to claim tax deductions on profits. From the employees' perspective, the profits of ISOs are taxed at the capital gains rate, not at the higher tax rate on ordinary income. Employees exercising NSOs are required to pay tax at the time of the exercise of options (purchase of stocks) and the sale of stocks.

 

For larger companies, ISOs are usually only offered to executives and/or key employees of a company. NSOs are also typically targeting management and senior employees, as opposed to qualified plans, which must be offered to all employees. 

 

For start-ups, ISO’s are more popular, given the small company size. Moreover, employee share options can only be exercised during the period in which the employee is working for the company.

 

Share Options terms you should know:

  • Vesting Schedule: This is the period in which you can purchase the company shares and take full control of the options contract. If an employee chooses to exercise his option before or after the vesting period, they will be required to purchase the stocks at the current market price.

  • Exercise Price: This is the specific price that employees can purchase the shares during the vesting period. It is listed clearly in the contract and the employee would be required to pay this price regardless of whether the current market price is higher or lower.

  • Grant Expiration Date: This is the date the contract expires. After this date, the employer is not required to honour the share options agreement. 

 

Benefits of Employee Share Options for Employers

 

An incentive to work harder: Giving employees share options will motivate them to work harder and more efficiently. A small piece of ownership serves as a reminder that they are working for the growth and benefit of the company. Share options will also help your employees feel more connected to your ideas and the company, improving productivity overall. 

 

Cost-effective Compensation Package: By offering share options, the employment package will appear more attractive to employees, while giving you greater room to negotiate other areas of the employment contract. Most start-ups have limited funds and may be unable to pay employees immediately. By offering share options, you can limit your immediate costs and shift them to the future while motivating your employees simultaneously.

Lower Employee Turnover: By choosing a vesting period that begins several months or years after the share contract was granted, you can reduce the risk of employees leaving your start-up. It essentially serves as a long-term guarantee for staff retention as vesting share options require employees to stay in the company for some time. 

 

 

How much Equity Share should start-ups give to their Employees?

 

The amount of equity share you should give your employees depends on a range of factors, but it typically ranges from 5-15%. If you are the sole owner of the company, you should be willing to give a higher percentage of equity.

 

If there are two or more owners, you may consider giving a percentage share on the lower end of the spectrum as you would want to maximise your shares. Moreover, since most start-ups tend to only kick off after a few years, it is typical to offer a vesting period of around 1-2 years so that you can ensure employees stick with you.

 

What you may consider before granting Employee Share Options?

  • Dilution of Shares: Dilution could be very difficult in the future as equity may not want to be distributed among more shareholders. If you want to provide shares for your family or friends, you may be restricted as you have already given some to your initial employees.

  • Difficult to Value Shares: Share options are difficult to predict and value in the future. There is a lot of uncertainty in how your start-up will perform and therefore it is difficult to predict the value of the share. If the market price of the stock is cheaper than the exercise price, then this would be an advantage for you as an employer. However, if the market price of the stock is higher than you would expect employees to exercise their options which may be unfavourable for you as they pay less for the stock.

  • Collective Effort: Growing a start-up and increasing its market value is a group effort, meaning that an employee must rely on other individual employees. A slack off or free ride from an employee can result in the whole start-up failing. Employees will be aware of this and may see no incentive towards working hard since they might not trust other employees to put any effort and thus won’t see the worth in doing so either.

 

Other Methods to Motivate Employees in a Start-Up

 

 

Non-monetary bonuses: Bonuses are typically offered in larger scale companies and are often given in the form of cash. However, as a start-up, you may not be able to provide cash with short notice. Hence, you can consider providing bonuses in non-monetary forms. For instance, if an employee enjoys music, you could purchase tickets to the next concert for them. Providing tailored bonuses for things that your employees value also demonstrates that you care about their interests and their value within the company, ultimately having the effect of improving productivity.

 

Happy Hours: Weekly, bi-weekly, or even monthly dinners and drinks with the entire team can have a meaningful impact on improving motivation for your employees. This is a relatively cheap out-of-pocket expense that can help build out of work relationships and connections.

 

Create Intrapreneurs: An effective method to motivate employees in a start-up is to help them envision themselves as intrapreneurs. This includes lower hierarchical structures and giving employees the freedom to choose their projects. This ensures that they are motivated, as they can choose what they want to spend their time doing. Of course, this level of freedom should only be given to employees to the extent that it benefits the company.

 

Documents you need to Grant Employee Share Options

 

Employee share options are a viable method for motivating employees and helping start-ups grow. It is an easy way to boost productivity whilst remaining cost-effective. However, there are many steps to consider when creating the contract.

 

We understand this may be difficult for you, which is why we compiled a free contract document for you to use. The documents are have been made in favour of you, the employer.

 

For an employment agreement between the company and a junior employee, please click here

 

For an employment agreement between the company and a senior employee, please click here

 

 

Please note that this is just a general summary of the position under common law and does not constitute legal advice. As the laws of each jurisdiction may be different, you may want to speak to your lawyer.

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