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Employee Stock Ownership Plan (ESOP): Ultimate Guide

Spela Prijon
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Having an equity stake in your company makes a huge difference to people's work. Equity is widely seen as a lever that increases the motivation and engagement of top talent.

Until recently, many European companies and employees saw equity and employee ownership as a ‘nice to have’ rather than a must-have until relatively recently. But today, adoption is increasing rapidly, and employee stock ownership plans (ESOPs) are the cultural heartbeat of many leading scaleups in Europe.

All the same, it's hard for scaling companies to get concrete answers to some tricky questions. Who owns the management of the company's ESOP? And how do you communicate the benefits of employee ownership? So let's dive in and explore employee stock ownership plans.

What Is an Employee Stock Ownership Plan (ESOP)?

An employee stock ownership plan (ESOP) is a structure set up by a company to give employees an ownership stake in the business. Companies set up ESOPs to compensate and incentivise employees, and to align everyone in the business behind the same mission and vision.

Most ESOPs give employees share options in the business. A share option is the right to buy a stake in the business at a certain point in the future.

Who controls the employee stock ownership plan?

The company's board of directors can choose who is granted access to share options under the terms of the ESOP. Some companies choose to grant equity to all employees, while others restrict share option awards to select groups of employees.

The directors also decide on exceptional decisions, such as when withdrawing someone's right to their equity if there is a case of – for example – gross misconduct.

ESOPs are useful for startups because younger companies rarely have the cash on hand to compete against much larger businesses for top talent. Instead, equity rewards employees for the long-term effort they put in helping to build the business.

Share options aren’t the only way companies can set up an employee ownership scheme. Some types of ESOP award actual shares rather than share options (like growth share schemes in the UK). In some countries (most prominently Germany) it’s more common to award virtual shares.

How does an ESOP work?

There are a few key components of employee share ownership plans that companies should bear in mind and prepare to communicate company-wide.

Vesting

Equity is designed to reward employees for their efforts over time, unlike, let’s say, bonuses which are paid out as a lump sum. It's important to set out for employees when they join how they'll earn their share options over time. In their share option agreements, it should state how many of their share options will vest each month, quarter or year (vesting normally happens in monthly increments).

Most stock options vest over four years, with a 12-month 'cliff' (a period of time the employee has to work before any of their shares vest). So a typical vesting schedule might look like this:

Example four-year vesting schedule with a 12-month cliff

Companies might decide on a different vesting schedule, but increasingly companies in different markets are cohering around the four-year schedule as a sensible way to manage the employee stock ownership plan.

Exercising

Exercising is the process by which employees buy stock in the company, turning their share options into shares. Put simply, employees buy their vested shares from the company (usually at a discount) by paying the ‘strike price’ per share. The strike price is the agreed price employees pay to convert options into shares.

Usually, the directors decide to open up a window for exercising options – a short period of time in which you can decide whether or not to pay the strike price per share and turn your options into shares. Exercise windows don’t come along all the time: typically, exercise windows open every couple of years, or at milestone events like funding rounds.

Exits and liquidity events

At some point, ESOP option holders and shareholders will aim to turn their equity stakes into capital gains and 'cash out'. This usually requires a liquidity event, which gives investors the opportunity to sell or exchange their shares for cash.

A liquidity event normally means an acquisition, merger, or initial public offering (IPO). During acquisitions and mergers, the acquirer typically buys out the company's shareholders, receiving some or all of their shares in exchange for cash. An IPO means the company lists on a stock exchange, making it much easier for employees and investors to sell shares.

Employees can realise a return on their equity without a liquidity event, though. More and more companies are opting to let some employees sell part of their stakes in secondary share sales. Most common in late-stage companies, a secondary share sale sees private investors acquire other shareholders’ options at the latest share price. They are often used to provide some liquidity to founders and/or long-serving employees without having to sell the company or go public.

Taxation in employee stock ownership plans

With most ESOPs, you don’t have any tax to pay until you sell your shares. Many ESOPs, like EMI in the UK and BSPCE in France, are designed to reduce your tax burden when you sell shares by treating profits as capital gains rather than income. In the UK, for example, this means paying between 10% and 20% tax when you sell your shares, rather than 40% or 45%.  

Other ESOPs don’t have the tax authority approval, which means you might have a higher tax bill to pay. Ask your employer if you’re not sure what type of employee stock ownership plan your company uses. In other countries, notably Germany, tax is paid when employees exercise their options and when shares are sold, making total tax obligations much higher.

Benefits of employee stock ownership plans

Talent attraction and retention

No question: the world's best tech talent expects equity alongside their cash compensation. Ambitious companies will find it hard to compete for great people without offering stock options. This is particularly true in early-stage companies that can't offer top-percentile salaries to new joiners.

A clear employee stock ownership plan also benefits recruiters: during the hiring process and at the offer stage, they can articulate exactly what percentage of the company a new hire will receive, providing clarity that could put the company in a positive light compared to other options the candidate has on the table.

Favourable tax treatment

Setting up an employee stock ownership plan means that your employees could see significant tax benefits when they 'cash out' their equity stakes. Employee share ownership plans that are approved by the relevant tax authority mean that capital gains from stock options are normally treated as capital gains rather than income. That means potential tax advantages: in France, the tax rate for BSPCE share options is 19%, while EMI share options in the UK are taxed at between 10% and 20%. In both countries, if employees' gains were taxed as income, the tax due would be over 40%.

Cultural alignment and engagement

Giving employees ownership in the business is perhaps the most effective way to get the team aligned behind the same high-level goals. Every startups goes through great times and tougher times. Giving employees a longer-term incentive that sits alongside their regular salary payments helps orient people's work around the long term. After all, equity "gives employees a sense of ownership over the business’s success," according to Ledgy CEO Yoko Spirig.

In the short term, equity can also help the team push to achieve big things: in Ledgy's 2023 State of Equity and Ownership report, we found that more than 80% of founders and operators agreed that equity increased motivation at work.

Different types of employee ownership

Employee stock ownership plans are only one way to grant team members a stake in the success of the business. Let's take a quick look at phantom or virtual shares and how they compare to

Phantom / virtual shares vs stock options

Virtual shares are another way to reward employees for their contributions to building early-stage businesses. Unlike actual employee share ownership plans, virtual shares do not give the holders any stake in the business. Instead, virtual shares translate to a cash value the employee will receive when there is an exit event like a public listing or acquisition. (Stock appreciation rights work in a very similar fashion.)

Just like ESOPs, virtual shares sit in a plan called a virtual share ownership plan (VSOP), which is designed to track the distribution of virtual shares among team members. Often, VSOPs for employees are carved out of the portion of the company stock owned by the founder, rather than a portion of the company's stock being reserved specifically for the team. Check out our comparison post for a deeper run-down of the benefits of ESOPs versus VSOPs.

Share ownership plans vs stock option plans

Most ESOPs distribute stock options to employees. But some ESOPs behave differently. In the UK, for example, growth shares are a popular way to give equity stakes to employees in early-stage companies. When employees receive growth shares, they become shareholders right away. The main difference is that growth shares have a 'hurdle' built in, meaning that the share price has to increase above a pre-set milestone before employees earn any right to their equity stakes.

Growth shares offer another way to give out company shares and structure your employee ownership – the key . Check out the key differences between growth shares and EMI options in our infographic.

Easily manage your employee stock ownership plan

Employee ownership is one of the most effective levers a company has to attract great people, align them behind the mission, and scale sustainably over the long term. And it's worth remembering that by setting up an approved ESOP, you'll create worthwhile tax benefits on gains accumulated for employees.

But managing employee stock ownership plans can mean headaches for the people in finance, operations, legal and/or people teams managing the ESOP. From calculating fair market value through to managing the sending and signing of hundreds of equity grant documents, managing an ESOP only gets harder as you scale.

That's where equity management software comes in. By automating many of the underlying processes, software like Ledgy saves time for your team and reduces the chances of costly errors. Learn more about how Ledgy's equity plan automation changes the game for anyone managing employee stock ownership plans.

FAQs

1. Why do startups need employee ownership?

For thousands of companies, and hundreds of thousands of employees, equity is now a core component of an employee benefit plan. Carefully structuring and defining your employee stock ownership plan – as well as making sure you establish your ESOP early on – could make a big difference in attracting great people and aligning the team behind the same mission.

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