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 1.3) and why it is important to always keep track of the options issued (1.4).
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 SHA 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
The board of directors is competent to set up the ESOP and to allocate options/shares to the participating employees. Hence, no shareholder approval is required for the establishment and execution of the plan.
Under an ESOP, however, the participating employees become shareholders of the company. To transfer shares to the employees, the shares must (i) either be ‘reserved‘ in advance in the form of conditional share capital (conditional capital increase) or (ii) an ordinary capital increase is required. The resolution on a capital increase or a conditional 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, a provision should be included in the shareholders’ agreement whereby the shareholders undertake to, if necessary to implement the ESOP, either (i) to create conditional share capital, (ii) to agree to an ordinary capital increase and to 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 the 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 according to a vesting schedule and can be ‘exchanged’ for shares once they have vested, or (ii) shares are transferred directly to the participants.
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 generally choose whether to exercise the options immediately (and thus become a shareholder) or whether to wait, e.g., to avoid triggering a tax liability in a specific tax period.
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). With the transfer of the shares, the exercise price must be paid. The difference in value between the exercise price and the tax value qualifies as income for the participant. For the company, this means that social security contributions must be paid on this amount. For the participant, the taxable income increases by the same amount.
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.
Advantage of direct share allocation (in the Canton of Zurich and certain other cantons): From a tax perspective, a period of 5 years begins to run when the shares are allocated. If the employee holds the shares for longer than 5 years, an unrestricted tax-free capital gain is possible for private individuals resident in Switzerland. In the blog post on the tax implications of an ESOP, we will go into more detail on this topic.
1.3 Why Options (from a company perspective)
Whenever possible, we recommend opting for options rather than shares when setting up the ESOP. This has two advantages in particular:
- Simplicity: If an employee leaves the company, the unvested options are forfeited. All vested options can only be exercised conditionally. 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.
- The retransfer of shares, on the other hand, is more complicated and always requires the cooperation of the employee who is leaving (which can cause difficulties in the event of a dispute).
- Tax: Options only become relevant from a tax point of view when they are exercised by the employee. When the employee does this is at his or her discretion (with certain restrictions).
- Even in the case of reverse vesting, the tax burden on shares arises with the allocation (in the difference between the issue price and the tax value). In other words, in most cases, before the employee has ever been paid one Swiss franc in cash. In those cases, it is possible that at the end of the year employees will receive a tax bill for income that they have only received ‘virtually’ in the form of share value.
The issue of options, therefore, has advantages not only for the company but also for the participants.
1.4 Manage and Administrate Options
After the ESOP based on options is introduced, the first options are soon issued to employees. 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?
- At what point in time were the options allocated?
- Overview of the individual vesting schedules
- How many options remain in the option pool?
- Are there options that have expired or are forfeited?
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. 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.
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).