What does Vesting mean, what is a Vesting Period and when will my Options become Shares?
Whether you’re a company setting up an employee share scheme (ESS), or an employee reviewing your ESS Offer, you are not alone if the terms confuse you.
You’re being offered a right, without any payment, to buy something, to get more rights, right?
Cue Austin Powers…
Below we cover the most common questions we get from both companies and employees reviewing their first ESS.
Each share scheme will have different terms, so it’s always important to understand how they may apply to you.
You have heard us rant about the benefits of ESS and ESOPs before – we clearly believe in them.
At Cake, our aim is to help make employee share schemes simple, for both the Company and the Employee.
1. What’s the difference between an Employee Share Plan (ESS) and an Employee Share Option Plan (ESOP)?
An Employee Share Plan offers employees Shares in the Company.
An Employee Share Option Plan (ESOP) offers employees Options in the Company (which, as explained below, become Shares).
In our experience, most private companies prefer to use ESOPs as there is no need to issue shares to the employees until the required ‘Vesting’ conditions have been completed.
Therefore, there is no need to issue shares (which come with voting rights, the need for ASIC updates etc), until the employee fulfils the conditions in the Plan Rules. It also means the employee doesn’t need to purchase the shares until there is value to do so. There are also other administrative and tax benefits which can apply.
2. What is an Option?
An Option is a contract, or a ‘right’, to buy shares in a Company.
An Option does not come with any rights usually allocated to shares, for example, voting rights or dividends.
The first stage of an ESOP involves the ‘Grant’ of an Option to the Employee. Basically, this is just the official moment that the Options are officially confirmed for that employee – fancy legal terms suck!
3. How does Vesting work?
What is Vesting? How does an Option Vest?
Generally under an an ESOP, you are not able to ‘Exercise’ your Option, until that option ‘Vests’. This means that you cannot turn the Option into a Share, until the Option has Vested.
The main purpose of having ‘Vesting’ conditions is so that the Options are tied to some obligation of performance or retention. This is how ESOPs are able to incentivise employees to stay at the Company longer, or work harder (or smarter).
Vesting happens either by way of time based vesting, milestone vesting, or a combination both:
a) Time Based Vesting
Time based vesting can either occur by way of a ‘Cliff’, or ‘Periodic Vesting’, or both.
Under a ‘Cliff’, a certain amount of Options Vest after an initial period has passed. Ie, 30% of Tracey’s Options will Vest after 12 months of working for the Company.
Under Periodic Vesting, the Options Vest gradually over a period of time (Vesting Period). For example, 60% of Tracey’s options will Vest quarterly, over 3 years of working for the Company, starting from the Cliff Date.
The Vesting Period will usually start from the Employees ‘Start Date’ of employment. However it can also be set to start at whatever date the Company likes. For example, a Company can create an ESOP where the Start Date for vesting is the same for all employees, regardless of when they started.
The Cake software automates this time based vesting once the ESOP Offer is accepted. This way, there is no need to keep track of what Options are vesting and when.
The Platform will also notify both the Company and the Employee of the vesting events occurring, and will allow the Options to be Exercised. It will also keep the Company updated of all the dilution as the ESOP progresses.
b) Milestone Based Vesting
Under Milestone based Vesting, Options will Vest on the achievement of some defined milestone. For example, the remaining 10% of Tracey’s options will Vest on her reaching $200k in sales for the Company during 2020.
c) What is the standard Vesting arrangement?
The most common vesting arrangements we see involve a 25% Cliff, followed by 3 year quarterly vesting for the remaining 75%. Some Companies will also add Milestones for certain employees, but only where it makes sense.
4. What does Exercising an Option mean?
When you ‘Exercise’ an Option, you are exercising your right to convert that Option into a Share of the company (usually an ordinary share).
To be able to ‘Exercise’ your Option, the Option must have ‘Vested.’
You will also have to pay the ‘Exercise Price’. This is all explained below.
A flow chart shows ESOP steps including grant, vest and exercise
5. What is the Exercise Price?
The Exercise Price is the amount the Employee must pay to Exercise each Option. The Exercise Price is the market value of the shares.
However, the amount can be calculated by different methods (approved by the ATO), which means the Employee will not necessarily have to pay any substantial amount to Exercise the options.
If the Exercise Price is high, the employee may also have the option to just keep the Options as ‘Vested Options’, and not Exercise them either until an Exit Event occurs, or they leave the Company.
This point often confuses people. For example, if an Employee received $25k worth of options as a subsidy for a salary cut, it would not make sense for the employee to have to pay $25k to Exercise those Options.
Here, there are a couple of solutions. Either the Exercise Price is calculated by an approved method which means the amount for those Options will be much lower than $25k, or the employee holds off on Exercising the Options.
By holding off, the employee could wait until a sale of the Company is approaching, to be able to Exercise them then and make a profit on the increased value. This will again depend on the specific Plan Rules.
6. What happens if the Company is sold before my Options Vest?
The ESOP Rules will specify what happens to the Unvested Options if an ‘Exit Event’, like a takeover, occurs. Usually, the Options will Vest automatically, and the employees will be given a chance to Exercise them, and therefore become part of the sale. This is sometimes referred to as ‘Accelerated Vesting’.
There may be different processes for Unvested Options, and Vested but Unexercised options, so it is worth checking your Plan Rules.
7. How will the dilution work?
Just because you are offered ‘3% of the equity’ of the Company at the time your ESOP offer is made, does not mean you will always own 3%.
Unless your ESOP includes anti-dilution rights (which would be highly unlikely), your percentage ownership will be ‘diluted’ each time more shares in the Company are issued.
For example, if after making your offer, the Company does a Raise and offers new shares for 20% ownership in the Company to an investor, your potential 3% ownership, has now become 2.4%, and so on.
However, this is not necessarily a bad thing. If the Company is getting more investments, it usually means the price per share is increasing. So you will now own a smaller part, of a bigger Cake.
8. What if the employee leaves?
Most ESOPs contain general ‘buy-back’ provisions, which allow the Company to buy Shares (and Options) back from employees in certain circumstances. One of those circumstances is when the employee leaves. ESOPs will specify the price that will be paid for those shares, often based on whether the employee was a ‘Good Leaver’ or a ‘Bad Leaver’.
These terms can be completely personalised for the Company, to cover any hypothetical scenario it may have in mind.
9. What about Tax?
How are ESOPs taxed?
Isn’t it great when the answer to the ‘what about tax’ question is a positive one!
ESOPs and ESSs can have decent tax perks if the Company (and employee) meet certain basic criteria (ie, if the Company is under 10 years old, has less then $50 million revenue, etc).
For example, if the ESOP Offer comes under the ‘Start Up Concession, the employee will not be taxed upfront as if it were cash remuneration. This will mean they are only taxed on the sale of the Options or Shares, by way of Capital Gains Tax.
In the words of the Tax Man himself, “under the start-up concession, an employee can reduce the taxable discount income relating to their ESS interests to nil.“
If you are not sure whether you meet the criteria to benefit from certain tax concessions, get in touch, and our tax and valuation partners can help you out.