ESOPs and Balancing Key Stakeholder Interests

This article is produced by CMS Holborn Asia, a Formal Law Alliance between CMS Singapore and Holborn Law LLC.

As the South East Asian start-up and emerging company scene continues to rapidly expand and mature, Employee Share Ownership Plans (“ESOPs”) are playing a key role in incentivising and retaining top talent in these companies. The potential exponential upside of holding options in a high growth company can be an important employee retention tool when pitted against the lure of higher salaries and perks of a larger organisation.

Whilst there are numerous benefits to an ESOP, there are some pitfalls that need to be carefully navigated. Here is a very short guide to some of the issues commonly encountered.

Traps and tricks

1. Conditions and KPIs: Time-based KPIs are not always effective when implemented as a standalone measure, unless the company has an active system of managing out non-performers. Target-driven KPIs can offer a better reward mechanism. For smaller companies, keeping a wider group of people involved may also be appropriate, especially in the formative years, with key personnel offered a higher percentage of options. The company should carefully consider what conditions or KPIs should be met before share options vest. These conditions should be set with the aim of allowing the ESOP to function as a motivational mechanism for employees.
2. Do we include a strike price? Generally, ESOPs are not a quasi-fundraising mechanism. That said, the rules should allow flexibility for the administrator to rebalance the scheme and adjust certain terms in future funding rounds with respect to new options being issued if the company is exhibiting high growth or has been substantially de-risked. Adjustments such as tying the strike price to the company’s last funding round or at a specified discount to fair market value may adequately manage the interests of new joiners and long-term participants who have shouldered comparatively more risk.
3. Voting Rights: It is common and often preferable for companies to create a new class of ESOP shares with no voting rights so that existing shareholders retain their ability to pass resolutions without the administrative burden of requiring further co-operation or consent from (often a material number of) ESOP shareholders. Alternatively, some founders may find it useful for ESOP shareholders to have voting rights, provided they are entrusted to a founder (or management) via a formal arrangement. This option can be helpful to founders in retaining an added degree of control over the voting process and to avert extra administrative issues and costs, particularly where there is a large number of voting ESOP holders.
4. Eligible Persons: With regard to private limited companies in Singapore which are unregulated entities, for example, the offering of options and issuance of shares under an ESOP would not generally trigger any securities law, compliance or disclosure obligations that generally apply to public/regulated companies in Singapore; however, complications can arise if certain pre-requisites for the applicable exemptions are not carefully monitored. Whilst offers of securities to persons in Singapore are generally subject to prospectus requirements under Singapore's Securities and Futures Act (Cap 289) (“SFA"), exemptions will generally exist when offers are made under employee share plans to an entity’s qualifying persons, namely, a bona fide director or equivalent person, a former director or equivalent person, a consultant or advisor, an employee or former employee of the entity or of a related corporation of that entity (being a corporation), or the spouse, widow or widower, child, adopted child or step-child below the age of 18 of such director or equivalent person, former director or equivalent person, employee or former employee. In addition, to avoid a scenario of becoming a public company (and, amongst others, being subject to additional filing, statutory and corporate governance obligations along with losing the ability to place restrictions on the transfers of shares), a private company should ensure that the total number of its members does not exceed 50 (not counting any former or current employee of the company or any of its subsidiaries). It is important to note that this 50 member rule does not exclude directors (where not employees), consultants or advisors - even though they fall under the prospectus exemption under the SFA.
5. Ensuring requisite shareholder approvals are in place: Before shares in the company can be issued under an ESOP, the share issuance would have to be approved by the existing shareholders of the company via an ordinary resolution under section 161 of the Singapore Companies Act (“CA”). Authority under section 161 of the CA can be obtained for a single issuance of shares or, alternatively, a “blanket” authorisation for the issuance of shares may be obtained by the shareholders for a period up to the company’s next AGM or when the AGM would need to be held. In addition to the foregoing, consideration should be given to whether there are any additional approval requirements under the constitution of or shareholders’ agreement relating to the company.
6. Maintaining good documentation hygiene: The documentation generally required in preparing an ESOP consists of: (1) the ESOP terms or rules document (which sets out the ESOP rules or the general terms of the options and the administration of the plan); (2) the letter of offer for eligible persons; (3) the signed acceptance of the offer; and (4) the exercise notice (being the form of exercise notice which scheme participants would be required to complete if they wish to exercise any of their options). Accuracy in record-keeping and efficient document management processes are important to ensure the proper administration of the ESOP. This is especially vital as the company grows and expands the talent pool of participants in its ESOP. To assist with administration, there are existing ESOP management tools available in the market that provide a range of solutions, such as the tracking of issued share options, vesting schedules, and payments. Such tools may be useful from the design phase of the ESOP through to its implementation and later administration.
7. Departing employees: Employee retention is a matter that no company is able to predict or guarantee. Leaver provisions, such as “Good Leaver” and “Bad Leaver” provisions, should be clearly set out in the ESOP rules in order to provide clear directions for dealing with options and shares where an employee leaves a company. Such provisions should clearly define when a leaving employee would be considered a “Good Leaver” or “Bad Leaver” and the resulting mechanism for determining the employee’s rights to his or her existing shareholding as well as both vested and unvested options under the ESOP.

We would also suggest that a company retains sole discretion to repurchase or undertake a capital reduction of shares held by ESOP holders where the company determines a repurchase or reduction of such shares is necessary and/or in the best interests of the company.

Conclusion

When structured and implemented effectively, an ESOP can achieve a win-win outcome for founders, shareholders, executive team members and employees alike. Its unique ability to engage, reward and incentivise participants makes it a highly valuable tool for emerging businesses to successfully attract and benefit from retaining top talent.