What is an employee stock ownership plan (ESOP)?

Many companies use stock options to attract and retain talent. And for good reason, since they’re a useful driver of performance. 

In fact, in a recent study of workplace benefits, 84% of employers and 97% of HR leaders said that stock-based compensation is the most effective way to keep employees engaged and motivated.

If you’re interested in offering stock options to help you stand out as a global employer, this article covers all the information you need, including the different types of stock options, how they work, and how to provide them to a remote team.

What is a stock option?

An employee stock option (ESO) is a type of equity-based employee benefit plan that allows employees to buy a specific number of shares in the company they work for at a locked price for a set period of time. The price set is called the exercise or strike price.

How does an ESO work?

If the exercise price is lower than the market price, the employee could make a profit by selling their shares of stock in the company later to supplement their base compensation.

This chance of obtaining a profit with stock price increases is why ESOs are such effective motivators of performance. It can offer a sense of shared entrepreneurship for your employees, bond workers separated by time zones, and help preserve the culture and vision of your company.

What are the different types of ESOs?

The two main types of employee stock options are:

• Incentive stock options (ISOs): You can only issue these to employees and executives

• Non-qualified stock options (NSOs or NQSOs): You can issue these to the groups above as well as contractors, consultants, and directors.

You can only issue ISOs to employees and executives, whereas NSOs are also available to contractors, consultants, and directors.

How does taxation differ by country for a global workforce?

Both types of ESOs also have different taxable events or triggers. In countries like the US, for instance, ISOs are exempt from income taxes, whereas NSOs are considered part of one’s taxable income at the time of exercise.

However, both options could introduce capital gains tax liability when the company shares are sold.

As an employer, you should carefully consider which would be more of an incentive for your employees to join your company and stay — the flexibility of NSOs or the favorable tax treatment of ISOs.

ESOs vs ESOPs

Many people confuse ESOs with employee stock ownership plans (ESOPs). Unlike ESOs, ESOPs are set up as trust funds that your company contributes common stock into, or money that can be used to purchase existing shares of company stock. 

In most cases, a bank loan funds this process, and the interest generated repays the loan. However, if your company has the capital, you can fund the ESOP directly.

Employees don’t pay anything for their shares. Instead, they are awarded as a benefit, with the possibility of accumulating more shares in the future.

When an employee does leave, they are usually entitled to keep the vested portion of their shares after the holding period. However, this generally depends on how long they have been at your company, as well as how your ESOP is set up.

In most countries, ESOPs are required by law to have a trustee who manages the plan’s fiduciary responsibilities. The trustee does not have to be independent, although this is generally considered best practice.

Types of ESOP

There are three primary types of ESOP: 

1. A non-leveraged ESOP is funded directly by cash or stock contributions from your sponsor or founding shareholder. It doesn’t require a bank or other lenders.

2. An issuance ESOP relies on financing. A loan is used to purchase newly issued shares from your sponsor, and these shares are allocated to the participants’ accounts as the loan is repaid.

3. A leveraged ESOP buyout also requires financing. The loan is used to purchase existing shares from a selling shareholder. This form of ESOP is often used during transitions, such as a company merger or acquisition.

You can offer both ESOs and ESOPs as part of your equity compensation benefits. It’s even possible to roll stock options into employee stock ownership plans.

How to set up ESOs

Setting up an ESO requires careful planning, compliance with securities laws, and ongoing administration. Here’s what you need to do:

1. Develop a comprehensive plan around your recruitment and funding schedules.

2. Define the program structure, i.e. NSO or ISO, and where it’s going to fit as a benefit that goes into your employees’ compensation packages.

3. Get a 409A valuation from an external firm to determine the fair market value of your stock and use that to set a strike price.

4. Set timelines for vesting and expiration.

5. Draft ESO agreements for your employees.

6. Get board approval for the agreements.

Remote’s global HR platform provides all the tools you need to offer equity incentives to a fully distributed team, from employees to independent contractors.

What are the pros and cons of an ESO?

An ESO has multiple advantages — but that doesn’t mean employee ownership is the right course for every company. If you’re going to offer this benefit, you need to be committed to employee ownership, and your company culture has to reflect this.

Here are some of the most notable pros and cons of an ESO.

Advantages of an ESO

The potential benefits of stock options that businesses of all sizes can expect to reap include:

• ESOs provide a succession plan for employers. An ESO offers a viable exit strategy, and ensures the business is left in the hands of its most invested guardians: your employees.

• ESOs foster a culture of engagement among workers. With an ESO, everyone has a collective interest in your company’s success. As part owners of the company, your employees may feel more willing and enabled to make suggestions on how to improve certain processes, rather than simply accepting direction. This is beneficial for morale, motivation, and productivity, as employees are no longer just “doing their jobs.”

• ESOs can encourage greater employee retention. According to a recent study, 78% of companies see better retention from improving their benefits packages. With a vested interest in how your organization is run, workers have a strong incentive to stay. If they accumulate more shares based on the length of time they’ve been with you, it’s in their financial interest to remain with your company.

Disadvantages of ESOs

There may also be challenges when using ESOs as your preferred form of equity compensation, including:

• ESOs need to be managed. The actual ESO itself requires administration. Aside from the financial planners you work with to set it up, you need a trustee to oversee it when it’s active. This means fees, legal expenses, and similar additional costs.

• Not all company cultures support employee ownership. If your company’s culture doesn’t encourage employee ownership, this form of compensation might not work. ESOs require a strong cooperative mentality and built-in values to be a success.

• ESOs require a strong leadership structure. If you decide to sell or leave your company, you need a strong management structure in place to manage your employee owners’ interests during and after the transition.

• If you sell, you will only receive the current market price. If you decide to sell or leave, potential buyers only have to pay the market value of your business. If your company is highly sought after, prospective buyers may have otherwise been willing to pay a higher price. 

How to calculate ESO payout values

The stock option sale prices on your plan’s individual benefit statements are usually determined by an independent, third-party appraisal firm.

These valuation firms use several factors to determine the stock share prices, including your current stock price, company income, your company’s assets, and market conditions.

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What happens to an ESO when a private company is acquired?

If your company is acquired, there are several potential outcomes. The equity-based compensation plan may remain in place, be absorbed into the acquiring company’s ESO in a stock swap, or simply be terminated. It all depends on the structure of your plan.

During a merger or acquisition, it’s the trustee’s role to step in and make sure the new owners are abiding by your ESO’s rules.

How are ESOs regulated?

While you can tweak certain elements of an ESO, they are still bound by government regulations. Due to the complexities of stock options, these rules differ by country, but generally cover the same areas. For instance, there may be contribution limits, documentation requirements, or minimum standards for investment plans.

Your ESO must comply with the employee ownership rules of the country or region in which it is formed.

ESO employee rights

When employees participate in an ESO, they should have access to:

• Information about the plan

• An annual performance report

• Individual benefit statements

• Official plan documents

In most cases, you don't need to provide your employees with official company financial statements. However, in the interest of transparency, many companies opt to do this.

Employees, as shareholders, are also given some voting rights. In private companies, ESO participants usually have the right to direct the trustee on the voting of allocated shares for sale of all (or substantially all) the company's assets. In public companies, ESO participants have the same rights as other shareholders. Participants are also entitled to information about the issues they will be voting on.

Provide stock options with Remote to seal the deal

Stock options motivate employees by making them part-owners of the company. As such, they’re directly invested in the company’s future growth, and their values are aligned with those of the company shareholders.

Remote provides powerful tools for employers to offer stock options on a globally distributed team and recruit the best talent.

Contact us today to find out how you can reap the benefits of equity compensation and maximize performance through ESOs.

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