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A beginner's guide to ESOPs (Employee Stock Option Plans) in Singapore

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If you’re a startup in Singapore, you know that you often need additional incentives to draw talent, as the pay that you offer cannot compete with other established players in the market. ESOPS (Employee Stock Option Plans) are a tool often used by startups and growing companies in order to compensate the employees in a way that doesn’t put a strain on cashflow in the present.

In this beginner’s guide we’ll cover what an ESOP is, the benefits of using one in your company, pitfalls to avoid and things to consider along the way.

What is an ESOP?

In essence, an ESOP grants employees the right to purchase shares of their company. ESOPs are administered by the company’s board of management who also lay down the rules of the scheme. A company sets aside an amount of its total equity to offer to key employees over a course of time. The company’s board of management sets the exercise price of the ESOP, but the price set is as close to the fair market value of the shares as possible.

 

There are two key concepts to an ESOP agreement:

  • The “vesting period”: how long it takes for an individual’s share to be drip fed to them over the course of their employment (typically 3 - 4 years)
  • The “cliff” or “lock in”: the amount of time an employee needs to stay (typically 1 year) before the ESOP ‘kicks in’ and they start to accumulate share options.

Why use ESOPs?

ESOPs have a lot of advantages for the company as well as for the employees:

Can be used as part of compensation package

When you have limited cash flow, you may have a desire to get the best talent but cannot pay their full market salary. A company may then supplement their remuneration package with other things – like share options – to bridge the gap between what they can pay their employee in cash and what the market salary is.

A drive to build value for the company

When employees feel like they own a part of their company, this sense of ownership in the employees can then have the flow on effect of aligning their incentives with shareholders – inspiring them to work more efficiently as they see their labour directly contributing to the business valuation.

Retaining employees

As ESOPs typically have cliffs and vesting periods, employees under the ESOP may be willing to stay until they are able to exercise their options.

Factors to consider with implementing ESOPs

Though there are a lot of advantages in ESOPs, there are a number of factors to consider:

Setting up the ESOP is complicated

Setting up an ESOP is a flexible but complex procedure with a lot of rules and regulations to be followed in each aspect and many different scenarios to consider. The initial cost of setting up an ESOP is quite high and should involve a lawyer.

What percentage of equity to put aside for your ESOP

There is no real hard and fast rule about how big your ESOP should be. However, it is recommended that the company should set a limit on the amount of equity that it wishes to share with the employees. For example, a company might set aside between 5 – 15% of the equity to be offered as ESOPs with each employee being given a right to buy equity between 0.5% to 3%.

ESOPs dilute equity shareholding

Along with other activities like fundraising, ESOPs result in ownership being distributed among a lot of individuals, which means that the founder may be left owning only a very small part of his company. This can sometimes cause complications when the company ‘exits’ (eg is sold or merges with another company).

 

To avoid a situation where option holders are able to block the company’s sale or merger, the company’s board of management should include a clause for drag-along rights that enable a specified majority of shareholders to force minority shareholders to sell their shares on receipt of a third party offer.

 

For a great example of how a startup journey might experience dilution through first hires, seed rounds, and series A, check out Alexander Jarvis’ medium article, “How does startup dilution work for founders, ESOPs, and investment

What happens when an employee leaves a company after shares have vested

The ESOP agreement should clearly contain a provision as to what happens when an employee who holds an ESOP leaves the company. Generally, an outgoing employee forfeits all his unvested options but retains the vested options till a specified short period of time.

Tax Implications

All the gains from ESOPs are taxable as per Singapore law regardless of where the ESOPs are exercised. This means that an employee of a company based in Singapore needs to pay tax on any benefit that he derives from these ESOPs. For advice on how the ESOP affects the company’s position, we recommend speaking to tax professionals.

So now what?

There are many resources out there to help founders get their head around ESOPs. Alternatively, you may also wish to speak to a lawyer who may assist you with setting up the ESOP. You may contact us at [email protected] if you require some recommendations on legal firms that may assist you on setting up the ESOP.

 

 

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