ESOP Employee Incentive Plan and its benefits

Chapters of the article

• What is an ESOP?
• What does an ESOP mean in practice?
• What are the benefits of an ESOP?
• What might discourage you from an ESOP?
• ESOP legal forms
• Implementing an ESOP in practice

What is an ESOP?

The word ESOP originated as an abbreviation of the English phrase “employee stock option plan.” At first glance, the English name may conjure up images of an option to acquire employee stock. However, this is not exactly what an ESOP is all about (or it may be one of the possible forms, but not the only one). An ESOP is an incentive scheme that can be introduced into any type of company, not just a public company. In particular, it includes a form of employee profit-sharing.

What does an ESOP mean in practice?

An ESOP is the distribution of a certain proportion of the company’s profits (in the form of real or virtual shares) to key employees. It is up to the employer to determine who can become such a key employee. The criteria for selection can vary, whether it is the length of employment, management position or the need for an initial investment by the employees. It is also common for the bonus component of the salary to be rolled over into a share of the company’s ESOP performance.

What are the benefits of an ESOP?

Are you considering whether an ESOP is a good choice for your company? There are a number of arguments to consider. Some of those that might convince you include:

• In a situation where quality employees are still in short supply, an ESOP can be your ace in the hole against competing companies. For employees, such an employee benefit can create a strong incentive to be loyal and not leave elsewhere.
• With an ESOP, you encourage teamwork in which everyone has a stake in promoting the success of the organization. It is actually a “win-win” situation. You get quality employees with a long-term incentive to stay and contribute to the company’s best possible economic results. For the employees, it’s an interesting financial incentive that translates into quality work.
• ESOPs can also bring interesting financial benefits, as they offer the possibility of obtaining external funding from your own employees.

What could put you off an ESOP?

• An ESOP requires experience in setting up and ongoing maintenance of the entire system, whether it is managed internally or externally.
• With any legal version of the system, it represents a fairly significant investment of time and money for the company.
• Taxation – is currently the biggest issue as it can be double (and sometimes triple) taxed, both as employment income subject to levies and as a capital gain if it is sold before five years. In rare cases, there may also be a third taxation, under the exercise of an option, where the difference between the market price and the employee price is taxed.

ESOP legal forms

Within the legal environment of the Czech Republic, we find two basic ways of grasping the ESOP system:

1) Real share in the company’s assets in the form of shares or shareholding

The advantage of this option is that it represents a more tangible form of shareholding for employees , but at the same time it is more difficult to process for the employees themselves and brings an unfavourable fragmented shareholder structure for the company. In the event of an employee leaving the company, it is then necessary to set up a relatively complex share buy-back system.

For the above reasons, it is generally not desirable for employees to be part of the shareholder base. In practice, this can be solved by setting up a separate company (Ltd.) in which employees are allowed to vote in the company’s bodies according to their shareholdings. However, the absence of a real share buy-back brings this option closer to the next legal form, i.e. a virtual shareholding.

2) Virtual (phantom) share

This does not involve the ownership of real shares, but the creation of a kind of “shadow shares” or the creation of a bonus scheme to be exercised when the company is sold.

This option is usually not linked to voting in the company’s organs. It is usually a contractually enshrined share of the positive economic result

Implementation of the ESOP system in practice

As can be seen, in reality, the system can have many modifications depending on many of the factors mentioned above. We will try to summarise at least what all these variations have in common and how the ESOP is implemented step by step in practice: First of all, the ESOP program has to be written down in the organization – all the above conditions and procedures are described transparently, along with the conditions for allocating shares to employees.

Subsequently, a share is allocated to a specific employee on the basis of a separate contract in the form of a share, a share in the narrower sense of the word, or a virtual share. The draft contract specifies the price at which the share can be acquired, the period within which the share option can be exercised and, as a rule, the period within which the share is subsequently acquired progressively. This part has a strong incentive component to discourage employees from leaving early. The period for the full vesting of the share is usually set at several years (about 5 years).

If the option period is fixed, it is advisable to address the relationship of the employee’s departure before the option is exercised in the contract, thus clarifying whether and how the right can be exercised after leaving the company.

At the same time, various objectives can be included in the contract, the fulfilment of which brings an additional incentive effect.

The most important part is the content itself , i.e. the value that the employee receives. For start-ups, this is usually a share of the purchase price on the sale (exit) of the company. A profit share or an extraordinary bonus is also a common form.

However, creating and setting up a transparent incentive system is not the end of the story. An important part of this is to make all employees aware of the plan and motivate them to participate in it. This is the only way the program can be truly effective and deliver what is expected of it.