The law in this respect is complex. Please note that this article does not, and is not intended to, constitute legal advice, and should not be relied upon as such. Slotine can assist in drafting bespoke incentive plans. Please contact us if you wish to learn more about this.
Employee Share Option Plans (ESOPs) are share-based incentive schemes that provide employees with the opportunity to acquire shares in the company they work for. ESOPs serve as an effective strategy for attracting and retaining high-performing talents while fostering long-term organisational growth.
The implementation and administration of ESOPs require careful planning and consideration. This article explores the fundamentals of ESOPs in Hong Kong, highlighting relevant regulations, key challenges, and best practices for companies looking to adopt a plan effectively.
Why and When to Adopt an ESOP
An ESOP is a strategic incentive tool that enables employees to acquire company shares at a preferential price, often subject to the satisfaction of predetermined conditions. It supports talent acquisition and retention by aligning the interests of employees and the company to promote business growth. ESOPs are often used alongside other employee incentives, such as cash bonus schemes.
ESOPs are typically introduced at key stages of a company’s development:
- early-stage growth – when companies seek to attract senior talent but sometimes lack the resources for competitive salaries, an ESOP can be used to attract individuals willing to accept lower wages for the potential upside of equity in the company they work for;
- first or second investment round (usually seed or Series A round) – when investors encourage the company to formalise long-term incentives as part of the executive hiring strategy;
- mature companies – an ESOP may be implemented to acknowledge and reward the loyalty of long-serving employees and/or employees in key roles.
Key Concepts & Characteristics of an ESOP
Option vs share
- An option gives the beneficiary the right (but not the obligation) to purchase a specific number of shares at a predetermined price, subject to certain conditions being met
- The share is the underlying equity that the option holder may acquire when they exercise the option
Class of underlying shares
- Usually non-voting shares (although ordinary shares may be issued)
Beneficiaries
- Employees, directors, and/or consultants participating in the ESOP
Pool size
- Typically ranges from 5% to 20% of the issued share capital
Grant price
- The price at which options are granted to the employee
Vesting schedule
- Typically a four-year vesting schedule with a one-year cliff (a period during which no option can be vested)
Exercise conditions
- Vesting usually depends on the beneficiary meeting predetermined exercise conditions at each vesting date
- Exercise conditions typically include performance conditions (based on individual and/or company-wide key performance indicators) and/or conditions related to continued service
Exercise price
- The price that the beneficiary can purchase the underlying shares upon vesting
Setting Up an ESOP
The different steps to adopt and implement an ESOP can be summarised as follows.
- Determine ESOP characteristics, such as defining the size of the option pool, identifying eligible beneficiaries and setting key terms for each beneficiary (including vesting schedule and exercise conditions).
- Draft ESOP documentation, including the ESOP rules, template option certificates and exercise notices, and corporate authorisations.
- Obtain corporate approvals from shareholders and directors (either through a meeting called in advance or written resolutions signed by all shareholders/directors).
- Grant options to beneficiaries, which involves acquiring relevant corporate authorisations and is usually formalised by issuing an option certificate to each beneficiary.
- Once the relevant exercise conditions are met, beneficiaries can exercise their options, leading to share issuance.
Throughout the life of the ESOP, it is crucial to keep the company’s secretary and auditors informed about key steps.
ESOP Share Transfer Restrictions and Managing Beneficiary Departure
Beneficiaries of an ESOP are usually subject to restrictions preventing them from transferring shares that have vested. These non-transferability provisions can be included in the articles of association, in an existing shareholders’ agreement or in a simplified shareholders’ agreement for each beneficiary. If the share transfer restrictions are contained in an existing shareholders’ agreement, beneficiaries will usually need to adhere to that agreement when they exercise their first vested options.
When setting up an ESOP, foresight is key to anticipate what happens when beneficiaries leave the company. Well-drafted ESOP documentation should cover the following scenarios in case of employee departures:
- what happens to granted but unvested options (do they lapse or another alternative?);
- what happens to shares issued when options vest (does the company have the right to buy back the shares, and are the purchase prices different for good vs. bad leaver circumstances?).
Without these provisions, the company may find itself with former employees remaining on the capitalisation table after their departure, which can complicate governance, dilute existing shareholders, and hinder future fundraising or corporate transactions due to a fragmented and less manageable shareholder base.
Tax Considerations
Granting share options is not tax neutral in Hong Kong. Employees are required to pay salaries tax on any benefits associated with ESOP shares. Assessment is made when an option is exercised rather than when it is granted. The gain chargeable to salaries tax is the difference between the exercise price and the market price of the shares at the time of exercise. Both the employer and beneficiaries should carefully report share option gains to the Inland Revenue Department. Additionally, if options are granted to beneficiaries outside of Hong Kong, tax advice should be obtained in the relevant jurisdiction.
Alternative Structures
Although ESOPs are the most common form of share-based incentivisation tools in Hong Kong, companies may choose alternatives to traditional share option schemes based on their size, geographical location and/or strategic objectives. These include:
- phantom (or ghost) shares: cash bonuses awarded to employees and calculated based on the value of the company’s shares – commonly used where direct equity ownership is restricted by local laws (typically in jurisdictions such as mainland China or Vietnam);
- restricted shares: shares awarded to beneficiaries upfront, subject to forfeiture if certain predetermined conditions are not satisfied – the shares are usually held by a nominee shareholder or in an employee benefit trust (EBT) until the conditions are satisfied; and
- EBT: an independent vehicle holding a pool of ESOP shares to be vested to beneficiaries of the ESOP – the EBT is usually the vehicle buying back shares from beneficiaries in case of departure.
KEY TAKEAWAYS
- ESOPs are effective incentivisation tools, promoting good corporate governance by aligning stakeholders’ interests;
- Bespoke and forward-thinking ESOP documentation allows companies to anticipate issues related to vesting, lapse of options and transfer mechanisms in case of departure;
- Alternatives structures, such as phantom share plans, restricted shares and EBTs, are usually considered where direct equity ownership is impractical or restricted;
- Strategic planning and communication with the company secretary, auditors and tax authorities is key to ensure compliance.
If you need help or advice regarding incentive plans, get in touch with us.
Photo credit: Romain Jacquet-Lagrèze