How do share option plans work?
Employee Share Option Plans (ESOP) refer to the mechanism by which a company offers to its employee(s) the right to buy a specific number (or a specific percentage) of shares in the company, at a specific price (the exercise price) and during a specified period (the exercise period).
During such period, the employee may exercise or not such option at a price determined by the company. This is just an option, not an obligation for the employee.
From an employee perspective, he/she may make a profit equivalent to the difference between the future valuation of the company and the exercise price.
On the company’s side, it’s a useful tool to reward and motivate key and loyal employees to stay in the company. ESOP is also seen as an alternative way to incentivise key performers and talent, rather than through salaries or other forms of monetary remuneration. It’s especially useful for start-ups or early stage companies with limited financial resources.
How big should an option pool be?
There is no universal rule on how large the option pool should be, and this should be determined by each company. However, the general market trend in Hong Kong suggests that a company is usually willing to offer 8% – 20% of its total share capital.
Again, this will depend on a number of factors such as the industry sector, the size of the company, the management culture, etc.
Vesting mechanism and class of shares
ESOP can be divided into several vesting option periods. It is also a common practice to impose a 1 year ‘’cliff’’ during which the option cannot be exercised.
Here is an example:
- 1st year: option cannot be exercised;
- 2nd year: the employee is entitled to 50% of the shares attributable;
- 3rd year: the employee can exercise its option for the remaining 50%.
The exercise option may also be subject to the fulfillment of specific conditions, performances and/or targets.
In addition to the different option periods, the company can also issue a separate class of shares. Indeed, rather than issuing and allotting new ordinary shares to an employee (who is conferred the ‘’classic’’ rights attached to ordinary shares, including rights to dividends, rights to information, and rights to vote at the Annual General Meeting), it is a common and popular practice for companies to issue non-voting shares restricting new participants from exercising their political voting rights. This can also facilitate the day-to day administration and running of the business.
The terms and conditions of the ESOP are quite flexible and can be tailor-made based on the company’s own strategic development. In other words, ESOP is purely based on contractual terms.
Who can benefit from ESOP?
ESOP does not only apply to employees, but may also be granted to directors, officers and/or consultants.
Is ESOP regulated in Hong Kong?
From a practical point of view, ESOP is comparable with dealing with the sale of securities, an activity that is normally regulated under the Companies Ordinance.
However, ESOPs fall under an exemption and there is no specific regulatory requirement or restriction provided that the offer of securities is made to the four categories of beneficiaries mentioned above.
Tax treatment of ESOP
No tax is levied on the grant/vesting of such stock option plan. However, salaries tax applies upon exercise of the option by the employee. The employer as well as the employee have to report such amount to the Inland Revenue Department for tax calculation purpose.
It’s relatively easy and low-cost to establish an ESOP. Such plan has to be adopted at the shareholders’ levels during the AGM and then approved by the director(s). Upon adoption of the plan, the company issues an ‘’Option Certificate’’, which sets out the terms and conditions of the ESOP. In addition, companies often issue an explanation note which provides more details regarding the procedures to be followed for the exercise of the option by the employee. Upon exercise of such option, the company will increase its share capital and allot the newly issued shares to the new participant. It is important to keep proper records of such transactions and comply with the statutory filings with the Companies Registry.
Shall the companies grant this option at the group/holding level or at the subsidiary level? On the face of it, the value is usually located in the holding company and therefore it would make more ‘’business sense’’ to grant shares at the group level.
However, it is important to note that such employee, through the allotment of shares in the holding company, will acquire (indirectly) controlling powers not only in the holding company, but also in every subsidiary…This should be decided on a case by case basis and with a cautious approach.
For more information on share option plans in Hong Kong please contact us.