The Beginner’s Guide to Employee Stock Option Pools
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Merely establishing a company with excellent ideas and execution mode is insufficient to run a company. An essential factor in running a successful startup has the required human capital to actualize these ideas. Unfortunately, getting good and reliable employees for your company can be pretty challenging.
It is even more difficult if you are starting your company and do not have sufficient funds to hire competent employees. You do not want to be penny-wise and mindless of your human capital as a founder.
Hence, one tested and proven way to attract competent and reliable employees is to create an Employee Stock Option Pool (ESOP).
Employee Stock Option Pools
What, then, is an ESOP?
An Employee Stock Option Pool consists of shares of stock reserved for employees of a private company. It is a block of company shares created and set aside for future company employees. An ESOP is a tool often used by startups and growing companies to compensate their employees in a way that does not strain the current cash flow.
Generally, the Employee Stock Option Pool is an employee benefit offered by a company to give employees the privilege to own part of the shares of the company they work for over some time. Usually, these shares are set over 48 months, just like the co-founders’ vesting schedule, and the employees will not exercise their full stock option until after the vesting period.
Following the expiration of the cliff, the employee is at liberty to exercise the stock options by purchasing the shares at the exercise price as they vest, subject to the terms of the ESOP. Accordingly, as a startup founder, an ESOP is a vital tool at your disposal to recruit and retain the kind of talent required for your company’s growth.
Why Should You Consider an Option Pool?
An ESOP creates motivation and encourages dedication from the company’s employees, especially when the company cannot afford to pay market rate salaries yet. By offering employees an opportunity to own part of the company’s shares, you encourage them to act as owners and do everything they can to help the company grow and share in its success.
An ESOP serves as an effective tool to attract talented employees who would feel more connected to the company.
An ESOP attracts investors to your company because investors are confident that the option pool will attract the best talent interested in the company’s success.
What happens when an employee leaves a company before all shares are vested?
Usually, the ESOP agreement contains a provision that defines what happens after an employee who holds an ESOP leaves the company before all shares have been fully vested. The general rule is that an outgoing employee forfeits all his unvested options but retains the vested options when they leave the company before all the shares are vested. However, when an employee resigns during a Cliff, he forfeits his right to exercise the stock options.
Employee Stock Option Pools
Tips to Create an ESOP
Arrange one-on-one discussions with your team members to ensure your goals align. Be open to feedback from your team and give realistic numbers when employees ask about the money they can potentially make on the sale.
Build the ESOP from scratch to suit the needs of your company. While drafting the ESOP, remember that the ESOP must be flexible, realistic, and employee-friendly. Employers should also consider the company’s financial health, needs, and objectives.
The ESOP policy should comply with the laws and rules of the country in which the company is registered. Also, confirm if an ESOP is taxable in your company’s country.
Get a qualified attorney to prepare your ESOP agreement.
Offer ESOPs in units and not in value to ensure fairness. This is because the value of $12,000 worth of options today would not remain the same after your company raised a fund. The number of units would be significantly different if you offered the same $1,200 options to someone else after fundraising.
Where Do You Include the ESOP?
Founders may include ESOPs in their founders’ and employment agreements. The agreement should stipulate the number of shares offered, exercise price, grant date, and waiting period before the stock options become exercisable.
Is ESOP Taxable?
Generally, whether or not an ESOP is taxable depends on a few factors, e.g., jurisdiction and the type of option granted. ESOPs can be made taxable in Nigeria under the Personal Income Tax Act.
Section 3 of the Act provides that all salaries, wages, allowances, other gains from employment, and other benefits are subject to personal income tax. Although this Act does not explicitly mention that a stock option pool is taxable, the section can make it taxable under gains from employment and other benefits.
In 2017, the Lagos State Internal Revenue Service (LIRS) issued a notice to ensure clarity and certainty mandating tax payment on employee shares or stock options. According to the notice, a gain will be deemed to have been made by an employee who acquires stock at zero cost or a cost below the stock’s fair market value.
In such cases, income tax is assessed against the difference between the purchase price and the stock’s fair market value. In addition, dividends earned on the stock during the vesting period will be subject to personal income tax.
Regarding the option granted factor, there are two types of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). These mainly differ by how and when they’re taxed—ISOs could qualify for special tax treatment.
An incentive stock option (ISO) is a corporate benefit that gives an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit. In the case of ISOs, the employee (option holder) must have held the shares for more than one year from the date of exercise and two years from the time of the grant.
Both conditions must be met for the profits to count as capital gains rather than earned income. Unlike other options, you usually don’t have to pay taxes when you exercise (buy) ISOs.
Non-qualified stock options (NSOs) are a type of stock option that does not qualify for favorable tax treatment for the employee. Unlike incentive stock options (ISOs), where you don’t pay taxes upon exercise, with NSOs, you pay taxes when you exercise the option (purchase shares) and sell those shares. This usually means you pay more taxes with NSOs than with ISOs.
You should seek the advice of a professional tax advisor to fully understand your tax obligations as an option holder.
Conclusion
Although the Employee Stock Option Pool is mainly an employee benefit plan, it benefits startups and their founders. Not only would it allow the company to attract talented employees and increase productivity and employee retention rates, but it also serves as a financial tool for the company when the employees exercise their options. However, to optimally enjoy the benefits of an ESOP, the ESOP must be structured appropriately and comply with the laws and regulations of the country where the company is located.
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