A Company, which wants to set up an ESOP, can do so by the
following ways:
Create
a Trust (Special Purpose Vehicle)
Give
options directly to employees
If it adopts the Trust route, it will have to issue shares or
options to the trust, depending upon the number of Options to be given to the
employees (as decided by the Compensation committee of the company).
The trust would need funds to buy these shares. For this, the
company can either given soft loans from its own funds or the trust can raise
loans through other sources to meet its financial requirement. The company can
act as a guarantee to the lender to the trust.
With the funds so raised, the trust then acquires
shares/options required. The trust can also purchase these shares from the
market or employees, if required, in the future.
The trust repays its loans as and when: -
The
employees purchase the options offered and when
They
exercise their options by paying the exercise price.
The Compensation Committee determines the number of options
allotted to each employee eligible employee, who would qualify under the plan.
The selection of the employees can be based on performance of the
employee-indicated by the annual performance appraisal, minimum period of
service, present and potential contribution of the employees, and such other
factors deemed to be relevant for the success of the company. Number of
options per employee can be determined taking into consideration, the grade,
level, years of service, salary, etc.
These selections would entirely depend upon the objective of
the company for setting up the ESOP.
The options (i.e. a right not an obligation) are granted to
the employees, to apply for shares of the company at a predetermine price (i.e.
exercise price). The employee can exercise the option only on completion of the
vesting period, which is determined by the Compensation Committee. The
requirements of vesting would typically be that the employee work with the
company for a minimum period till the options becomes exercisable. The employee
can exercise the option during the exercise period after vesting, otherwise the
options lapse.
The real advantage of ESOPs is because the exercise price
remains fixed over the term of the option. So, the employee would exercise his
option when the market price of the shares goes substantially high and he would
gain on the difference between the market price and exercise price.
FREE online courses on ESOP - How Does ESOP Work - Exploring The ESOP
Concept
The first step in the process of establishing an ESOP is to
develop an idea of the type of plan that will best serve the company's
interests. Companies have created ESOPs as an employee retirement plan, for
purposes of business continuity, financing, enhanced employee motivation or as a
combination. Normally, companies going in for ESOP go through the following
process: -
1. Conceptualizing the Scheme
Designing The Specifics
This is
the most critical step in the entire ESOP process. At this stage the management
lays down the broad policy and framework of ESOP. Critical issues, which need
to be addressed in this phase, are:
What do
we want to achieve from ESOP?
What
kind of risk should the employees take when investing in shares of the Company?
What
should be the percentage holding earmarked for ESOP?
Should
the employees take the risk of investment or should they be issued cashless
options?
What
should be the vesting period for option?
How do
we link the performance appraisal process to ESOP entitlement?
Once you have a general picture of the kind of ESOP you want,
The actual feasibility of an ESOP needs to be established. Custom-tailored
answers to the many questions need to be answered. Who will participate in the
plan? How will stock be allocated to participants? What vesting schedule will be
adopted and how will distributions of ESOP accounts be handled? How will voting
rights is handled?
In the case of a privately held company, the feasibility and
design phase of the process is not usually complete until three additional
points have been addressed.
First, an independent appraiser must value the
firm's stock before shares are put into the ESOP. Initially, a careful
estimate should be prepared for use as a working figure in the
feasibility and design process.
Second, the ESOP's effect on existing stockholders
should be estimated. Stockholders will want to know how the ESOP will affect the
value of their stock and the company's financial condition. Often an ESOP will
cause a dilution of their equity interest in the corporation.
Finally, while not a requirement for establishing an
ESOP, a plan for meeting the private closely held company's obligations to
repurchase the stock of departing employees should be projected. This
"repurchase obligation" arises from the fact that in privately held companies,
ESOP participants have a put option when leaving the company. Companies may plan
for and meet their ESOP repurchase obligation in a variety of ways, including
making substantial cash contributions on an annual basis, and buying insurance
to cover the plan's obligations. If the likely growth of repurchase obligation
over time is projected at the outset, however, the company is in the best
possible position to plan for it and design the ESOP accordingly.
2. Financial Modeling
ESOPs have wide financial implications for the company. It
has impact on the share capital, share holding pattern, accounting impact,
financial commitment (in case of buy-back, cashless options or phantom options).
In this phase all these issues are addressed.
3. Employees Interaction
To ensure the success of the scheme, it is necessary that the
employees understand the scheme. Their concerns and views should be addressed in
the scheme document. Thus it is necessary to interact with the employees to
explain them the scheme, clarify their doubts and also incorporate their
feedback in the structure of the scheme.
For ESOP to be effective, a regular communication with the
employees and transparency in the allotment process is very critical.
4. Drafting of Legal Documents
Putting The ESOP In Place
Typical documents to be drafted are the ESOP scheme, Trust
Deed, (in case a Trust is going to administer ESOP), Grant Agreement, Option
Certificates, relevant Board and shareholders' resolutions etc.
When the process of analyzing and designing the ESOP
is complete, the company will typically have an attorney prepare a
formal plan document which will set forth the specific terms and
features of the ESOP. An appraiser will then prepare a finished and
formal evaluation report, based on data preferably no more than 60 days
old at the date the ESOP is created.
