Employee share option plans (or ESOPs) are a key tool for startups to incentivise staff and hire talent when funds are tight. Unsurprisingly, one of our most-used Southeast Asia resources is our ESOP rules template, and the accompanying doc maker.
Preparing ESOP rules based on our free resources is easy enough, but we find that founders need guidance on putting the scheme in place after creating the ESOP rules. We’ve put together this guide to help you through the steps: from drafting the ESOP rules to adopting the plan and granting options.
draft the ESOP rules
ESOP rules set out matters that apply to all options granted under the scheme, such as the process for granting options, how employees can exercise their options, what happens to the options on an exit event, or if an employee leaves.
If you’re using the Simmonds Stewart ESOP rules, you can either use the doc maker to create your own document, or you can download our template and follow the user notes to complete the drafting. The document that you generate will consist of a set of rules governing the scheme with the following schedules:
- schedule 1 – a letter of grant setting out the terms of the options you want to grant to recipients
- schedule 2 – an exercise notice which is delivered to the company when an option holder wants to exercise options
- schedule 3 – an option certificate which records the number of options, exercise price and vesting schedule.
key features of ESOP rules
|size of option pool
|the maximum number of options that can be allocated under the ESOP without amending the terms of the ESOP or adopting a new option plan. Usually an ESOP pool is around 10-15% of a company’s total shares on a fully diluted basis. If you are setting up an ESOP as part of a capital raising transaction, the incoming investors may have their own view on the size of the option pool.|
|the price per share that option holders will pay on exercise of options. This is often the market price of a share at the date of grant of the option (i.e. the date of the letter of grant) but can be fixed to be lower. Generally, option holders are liable for tax when they exercise options based on the difference between the exercise price and the market price of the shares at the time the option is exercised.|
|a committee can be appointed to administer the scheme. Initially the board of most startups carries out this role. If there is a separate committee, the ESOP rules should set out how this committee is constituted.|
|the final date by which an option holder must exercise his or her options. Consider what is appropriate for your company – i.e. the likely time frame for a liquidity event vs the period during which you are comfortable having options outstanding. Typically in Southeast Asia this might be between 5-8 years from the date of grant, which is a likely time frame for an exit to occur.|
|options often vest over a 3- or 4-year period. Vesting incentivises option holders to stay with the company throughout the vesting period, in order to be able to exercise all of their options. Generally, if an option holder leaves before the end of the vesting period, he or she will lose their unvested shares.
our template ESOP rules allow for recipients to have personalised vesting schedules. Shorter vesting periods, or fewer options being subject to vesting from the outset, may be appropriate for employees who have already made significant contributions to the business prior to the grant date.
|cancellation of options||sets out what happens to options if the holders leave the business. Often, a distinction is made between good leavers and bad leavers depending on the circumstances of their departure. This can have an impact on what happens to vested (as well as unvested) options held by the leaver.|
|sets out what happens to options on a liquidity (exit) event. Our template rules provide that all unvested options immediately vest on an exit event, and must be exercised before completion of that transaction.
some companies prefer the approach commonly seen in the US where acceleration is more limited. We cover the alternatives for acceleration of vesting in more detail below.
|options are personal to the holder, and your ESOP rules will generally make it clear that options are not transferable without the approval of the board. Equally, the rules may separately restrict any transfer of shares issued on the exercise of any options.|
|if there is an liquidity (exit) event, the company might like the ability to cash settle options by paying an option holder the difference between the value of the option shares at time of the liquidity event and the exercise price for each option being cash settled. Our template rules permit this approach.|
|at the time an ESOP is set up, the company will most likely have a shareholders’ agreement in place. Our ESOP rules require that option holders sign a deed of accession to that shareholders’ agreement.|
|the rules may contain drag-along rights, requiring the option holders to sell to a potential buyer on exercise of their options, where the majority shareholders require this.|
the acceleration conundrum
The part of your ESOP which requires the most thought is what happens to options on a liquidity (exit) event. As described above, our template rules provide for full acceleration (also known as single-trigger acceleration); that is, all unvested options vest on an exit event and can be exercised in full. Full acceleration is the most employee-friendly position. However, potential acquirers of your company can be put off by full acceleration, as they often want key employees to stay on to continue growing the business. We find there is a lot of variation in Southeast Asia on this point, as compared to the US, where it is more common to adopt a double trigger acceleration mechanism (more on this below).
The options are:
|none of the unvested options vest on an exit event, and any unvested options expire. Option holders can only exercise options which have vested.|
|a percentage of the unvested options vest on an exit event. The remaining options continue to vest in accordance with the vesting schedule.
this can be important to a buyer where employees remain employed by the surviving entity, so that they continue to work for the business and earn their options. However, it can be less appealing to employees, who will lose unvested options even if they are terminated without cause.
|double trigger acceleration
|a percentage of the unvested options vest on an exit event. The remaining options vest subject to a second trigger, which in a sale scenario is generally if the employee is terminated by the acquirer or surviving entity (or resigns where they have good reason) in connection with, and within a certain time after, the exit event.
that way, if the second trigger event does not occur, the employee must stay with the company in order to earn their remaining unvested shares. However, if a buyer does not choose to keep an employee after an exit, the employee is not penalised for this.
in Southeast Asia, we do not see double trigger acceleration very often but expect that to change as some of the larger tech companies adopt Silicon Valley practices.
approve the rules and the option pool
Before you can start using your ESOP, your directors and shareholders will need to sign some corporate approval documents, described below. For Singapore companies, all resolutions will be prepared by your corporate secretary. If your company is based elsewhere in Southeast Asia, we recommend checking requirements with a local law firm.
The directors of your company will need to approve the ESOP rules and put them in place. You should ask your corporate secretary to prepare a set of directors’ resolutions in writing for the directors to sign. The resolutions should include the following:
- that the directors approve the ESOP rules circulated to the directors
- that the directors are authorised to grant specific numbers of options to recipients of their choosing, and issue shares on exercise of the options, in accordance with the approved rules, up to the total limit of the pool of options specified in the rules
- the total maximum number of options in the option pool.
The shareholders of the company will also need to approve the grant of options up to the maximum size of the pool, and the issue of shares on exercise of any of those options. You should ask your corporate secretary to prepare a set of shareholders’ resolutions in writing for all of your existing shareholders to sign. The resolutions should include the following:
- that the shareholders approve the ESOP rules circulated to the shareholders
- that the shareholders approve generally the grant of options, and issue of shares on exercise of options, in accordance with the approved rules, up to the total limit of the pool of options specified in the rules
- that the directors are authorised to grant specific numbers of options to recipients of their choosing, and issue shares on exercise of the options, in accordance with the approved rules, up to the total limit of the pool of options specified in the rules.
shareholders’ waivers and consents
You should also check your existing constitution and shareholders’ agreement (if any) to see whether the existing shareholders have pre-emptive rights on the issue of new shares. If your company has adopted the ACRA model constitution, the existing shareholders will have pre-emptive rights.
If this is the case, those shareholders will need to waive their pre-emptive rights in respect of the grant of options, and issue of shares on exercise of options, in accordance with the approved rules, up to the total limit of the pool of options specified in the rules. You should ask your corporate secretary to prepare this shareholders’ waiver.
Finally, you should also check your existing constitution and shareholders’ agreement for any specific consents required from anyone in order to issue shares, grant options, or establish an ESOP. For instance, if you have been through any external funding rounds, you may have given an investor a veto right over any new share issues. If that is the case, you will need that party’s written consent to grant options and issue shares under the ESOP. Your corporate secretary should hopefully be able to prepare these written consents as well.
Each time you want to grant options, you should ask your corporate secretary to prepare a new set of directors’ resolutions in writing, approving the grant of the specific number of options, the recipient, the exercise price, the vesting schedule, and the issue of shares on exercise of the options.
letter of grant and option certificate
Once you have approved the ESOP rules and passed all the resolutions, waivers, and consents referred to above, you can start allocating options to employees, directors, and contractors of the company.
To do this, you will need to send the recipient an offer letter setting out the terms of the options you want to grant to them. Our template rules include a template letter of grant at schedule 1 of the rules which you can insert into a new document and use as a base.
The letter should set out the number of options being granted, the exercise price, and the vesting schedule. For each recipient, you should send this letter out with a copy of the rules attached. The schedules in the attached rules would be left blank.
If the recipient accepts the offer, they should counter-sign the letter of grant and return it to you. Once you have received the countersigned letter, you can issue an option certificate, which sets out the number of options, exercise price, and vesting schedule. In our template rules, a sample option certificate is included at schedule 3.
Internally, you should also be keeping an option register, which is a record of all the options the company has granted, their vesting schedules, expiry dates, and exercise dates.
If an option holder wants to exercise their options, the first thing to do is check whether those options have vested in accordance with the option holder’s vesting schedule and have not expired under the ESOP rules.
If the options have vested, the option holder should deliver an exercise notice to the company. Our template rules include a template exercise notice that can be used for this. If you’re using our template rules, the process for exercising options is set out in Rule 5.3 as follows:
- the option holder must provide at least 10 business days’ written notice to the board that they are exercising their options, using the form set out in schedule 2 of the rules
- the option holder must pay the total exercise price for the options on or before the date set out in their notice
- once the option holder has provided their notice and paid the exercise price, the company must issue the corresponding number of option shares to the option holder.
The process to set up an ESOP is not too difficult once you’ve drafted the rules, and your company secretary should be able to prepare all the necessary resolutions.
One final tip: often you won’t have an ESOP in place when you first raise money. If you are required to establish an ESOP within a period of time after closing a capital raising transaction, it’s a good idea to get all the written approvals in place at the time of the deal. This will save you the hassle of having to go back to shareholders to get more documents and resolutions signed.