How does ESOP work?
Employee Share Option Plan (ESOP) refers to the mechanism by which a company (which can be either private or listed) offers to one of more 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, usually within a number of years (the exercise period).
During such exercise period, the employee is free to exercise or not such option at a price which is determined by the company at the time of the grant. This is an option given to the employee, not an obligation.
From an employee perspective, he/she is expecting to make a profit equivalent to the difference between (i) the future valuation of the company and (ii) the exercise price.
On the company’s side, it is a useful tool to reward and motivate key and loyal employees to stay in the company, by granting them equity interest to share any future growth in profits. ESOP is also seen as an alternative way to incentivise key performers and talent, rather than through salaries or other forms of monetary remuneration (especially useful for start-ups or early stage companies which have 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 between 8% to 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 (this is to give both the company and the employee a sufficient period of time to see whether they wish to commit to each other for a longer period).
As an example, the ESOP can be planned as follows:
- 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 fulfilment 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 (e.g. without any voting rights, the employee is not required to attend a shareholders’ meeting, and his/her signature is not needed to pass a resolution).
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 (i) directors, (ii) officers and/or (iii) 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 (Winding Up and Miscellaneous) Ordinance (Cap. 32), which sets out a number of restrictions over the publication and sale of securities to Hong Kong investors.
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 (i.e. employees, directors, officers and/or consultants).
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 are both required to report such amount to the Inland Revenue Department for tax calculation purpose.
However, the ESOP does not count as relevant income for MPF purpose.
It is important to note that employees based overseas who exercise their ESOP option may also be subject to salaries tax in this overseas jurisdiction (unless there is a double tax treaty for the avoidance of double taxation).
It is relatively easy and low-cost to establish an ESOP. Such plan has to be adopted at the shareholders’ levels during the AGM, before being approved by the director(s). Upon adoption of the plan, the company is legally required to issue an ‘’Option Certificate’’, which sets out the terms and conditions of the ESOP. It is also common for the company to 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.
It is often asked whether such option shall be granted 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.
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