Many fast-growing companies are catching on to the concept of employee share schemes and other equity models as a tool to help them acquire and retain key staff while freeing up cash flow. But it’s not always simple to determine the best model for your business, as every scenario is different.
A common question we get asked is whether it’s better to adopt an employee share scheme (ESS) or an employee stock ownership plan (ESOP), and what the difference is between the two. To understand the difference between an employee share scheme and an employee share option plan, one must first understand the difference between a share (or stock) and an option.
What are Shares?
A share, otherwise known as a stock, is a unit of ownership in a company, which provides the holder of that share rights to income and or capital of the company. Ordinary shares also carry proportional voting rights.
For example, Fuzzy Pty Ltd has issued 100 shares. 90 shares are owned by Bob and 10 shares are owned by Tim. The shares issued are ordinary shares. When Fuzzy Pty Ltd declares a dividend, Bob will receive 90% of the income as he holds 90% of the issued shares.
At the annual general meeting (AGM) the shareholders must appoint a new CEO. As Bob is the majority shareholder, his can out-vote Tim on the decision to be made.
One thing to consider is that minority voting interests might be protected by a shareholders’ agreement. Companies adopt shareholders’ agreements for a number of reasons but mostly as a way to mitigate risks before they arise. BlueRock's commercial lawyers can assist with any questions you have about shareholders agreements, partnership agreements and term sheets.
What are Options?
An option is the right (but not the obligation) to buy a share(s) before a specified future date (vesting date) at a predetermined price (strike price).
When looking at the difference between employee share schemes and employee stock ownership plans, remember that a share is a fixed interest of ownership in a company whereas an option is a contract dealing in an underlying asset. For the purposes of this article, the underlying asset is a share in a company.
If the owner of the options contract does not exercise this right, the contract will expire. Like shares, options can be traded.
Key Differences Between ESS and ESOP
To keep it simple, employee share schemes, or ESS, allows employees to purchase or be awarded shares at a predetermined price. Employee stock ownership plans, or ESOP, allows employees to purchase or be awarded the right but not the obligation to purchase shares before a specified date at a predetermined price.
There are a few other key considerations.
Timing of income and influence on employee share schemes
ESS participants can receive dividends as soon as they are declared whereas option holders need to wait until they convert their options to shares down the track. Share scheme participants can also vote at upcoming general meetings effective immediately.
Who can participate in an ESS or ESOP?
If start-up concessions are applied and the employee share scheme interest is a share, in order to reduce the discount treated as assessable income to zero, the scheme must broadly be available to 75% of employees who have completed at least 3 years of service.
When applied to options, the scheme can be applied to any number of participants.
Freedom to read the market
When an ESOP is implemented by a business, at the time that the shares vest, there are a couple of ways it can play out. If the market price of shares is above the strike price of the options, the participant can make an immediate capital gain.
If the market price of shares has significantly dropped, the participant may choose not to exercise the options or, if available, buy the shares at a lower market price than the strike price.
Keen to Learn More about ESS or ESOP for Your Business?
It’s crucial to decide on a scheme the is appropriate for the current and future needs of your business and to structure your equity model in a way that effectively allows you to take advantage of the available tax concessions.
For further advice about employee incentive models for your business, please reach out to our accounting advisors who have great experience working with high-growth businesses to help them achieve their goals.
