Developing and implementing an employee stock option plan in a private, owner- managed business that is meaningful to employees and achieves corporate objectives is undoubtedly challenging. Potential pitfalls to owners include structuring an effective ESOP across multiple jurisdictions, having to provide financial disclosure, having to consider minority rights, taking into account employment and securities laws, being subject to greater employee scrutiny, and, of course, the cost and time required to design, implement, and maintain an ESOP.
Potential pitfalls for employees include not achieving the vesting requirements, not having the resources to buy the shares, lowered expectations in terms of salary increases and bonuses, and the potential lack of liquidity.
In-house counsel play a key role in structuring and implementing ESOPs given the need to involve and co-ordinate the advice of in-house and external financial, legal, and human resource experts as well as interacting with the board of directors.
The legal team needs to carefully consider the impact of options on other compensation issues — such as salary, commission, bonus, benefits, termination packages — and craft the plan document and other employment agreements and communications materials to ensure the company has flexibility to administer the plan and that they are not in conflict.
A key area of focus is termination of the employment relationship on vested and unvested options. The courts typically require clear and convincing language in regard to the forfeiture of option benefits.
Keeping the offer letter separate from the ESOP can help avoid exposure on entitlement issues. It is also prudent to condition the employee’s eligibility to exercise options following termination to the employee honouring his or her confidentiality, non-solicitation, and assignment of intellectual property obligations.
Stock option compensation is typically considered employment income across most jurisdictions; however, the timing and rate of taxation varies among different countries.
Generally, stock options are taxed when exercised. However, in some jurisdictions they are taxed at grant, albeit subject to certain exceptions. Knowledge of the financial position of employees is important when considering timing of taxation and whether it may pose a financial hardship for employees.
Some European countries and the United States provide more favourable tax treatment to both employees and the company if certain provisions are included in the ESOP. But the downside is that the employer must contend with complex and sometimes onerous administrative burdens affecting minimum vesting periods, tracking of holding periods, and option pricing requirements.
In-house counsel should feed back these requirements to management so they can be taken into account before going too far down the road of drafting the plan.
Commonly, vesting periods are simply tied to the passage of time. Shares vest on an annual, monthly, or weekly basis for as long as the employee remains employed. This need not be the case.
Vesting can also be tied directly to the company achieving measureable, objective metrics, including sales, profits, or enterprise value. Tying the vesting of options to such metrics can help ensure corporate objectives are met.
Sometimes, a mix or combination of vesting (some immediately, some over time, some tied to company performance, some tied to personal performance, etc.) works well.
In-house counsel are well positioned to help identify and define those metrics and ensure they are in line with the company’s strategic and operating plans and not inconsistent or unintentionally duplicative of other compensation arrangements such as bonuses.
One of the most significant challenges to an ESOP within an owner-managed business is the potential wresting of control, either de jure or de facto.
Preserving complete control over day-to-day management as well as fundamental decisions does not work well with ESOPs, even if exercised options are non-voting. Employees will likely feel entitled to participate in decisions affecting the value of their options and management will be held to higher scrutiny.
It is essential that management anticipate this change and tangibly provide employees with additional insights into the running of the business.
A serious challenge for ownership is that some or all employees may expect material financial disclosure. Owner managers may be decidedly uncomfortable with opening their kimono as it may give rise to larger questions regarding compensation, the direction of the company, and the like.
Providing employees with tangible means to influence management may help avoid or forestall providing damaging financial disclosure.
Failure to address what will happen to outstanding options, both vested and unvested, in the event that an opportunity to do an initial public offering occurs, or in the event the owner receives an offer to purchase the business, can be catastrophic. Employees could stand in the way of an IPO or sale.
ESOP provisions need to address whether vesting should accelerate, or unvested options terminate, or the employee should be given a short period of time to elect to exercise vested or unvested options.
Normally, plans provide for 100 per cent of unvested options to accelerate. The exercise of shares is usually timed to the closing of the IPO or sale, so that the participating employees can use their share of the sale proceeds to pay the exercise price for their shares.
In almost all cases, the owner manager has the ability to IPO or sell the company and to force the participating employees to participate.
It is generally prudent to build in provisions that will survive an IPO. The ESOP should take securities legislation and stock exchange requirements into account to ensure the ESOP meets regulatory requirements should the company go public to help smooth the transition.
Communicating the ESOP
Ideally, after the draft ESOP has been socialized and accepted in principle by the board and before it is submitted for adoption, the plan should be communicated to the participating employees in a manner that is clear, straightforward, convincing, and motivating.
In-house counsel can play a critical role in helping to “sell” and convince employees to “buy into” the plan. Failure to properly anticipate questions, plan, and implement this critical step could make all the previous work meaningless.