How are ESOPs allocated?

An Employee Share Ownership Plan (ESOP) can be a highly successful way to engage and motivate current staff or attract new employees by offering equity, in the form of shares, as an incentive rather than bonuses or high salaries. But what’s the best way to set up a share ownership plan? And how do you decide how to distribute shares fairly? In this article, we’ll answer all your most pressing questions.

First, an introduction to ESOP

Employee Share Ownership Plans (ESOP) is the umbrella term for a few different schemes companies can offer their employees.

There are a few different types of ESOP programs for their employees. An options scheme offers employees equity, in the form of options, which can benefit both the employee, as well as start-ups and high-growth companies if the company grows in value over time. There are also more profit-based schemes that can have significant benefits for employees in profitable, private businesses. These include Loan to Purchase, Phantom (or Bonus Shares), and Managed Buy-outs. See ESOPs: A Comprehensive Guide for more detail.

These employee equity plans can be offered to all employees or key employees only. It is a process that a company can choose to go through to offer equity in the form of formal equity (shares) or profit-sharing to an employee (or contractor) over a period of time.

Understanding how employee profit-sharing works offer an appealing way to introduce long-term incentives without immediately drawing cash out of business.

What benefits do ESOPs have for key employees?

ESOPs offer staff the chance to invest in a company and potentially earn significant returns, typically without having to find the money to make a sizable lump sum payment upfront.

Research shows that employee-owned businesses on average, perform better than more traditionally-owned businesses. This is understandable because when increasing employee engagement through ESOPs, staff are given a sense of ownership in the company they work for. Staff allocated share ownership from their employers report higher job satisfaction and motivation. Some companies offer shares to employees throughout the company so that they don’t simply benefit a select few for this reason.

What’s in it for employers?

ESOPs form a strong tie between a company and its employees when staff can purchase shares in the company at a set, often competitive, cost. Some benefits to the employer include the following.

• Enhancing employee retention
• Boosting workplace culture & job satisfaction
• Increasing productivity & profitability
• Maintaining customer loyalty through improved service

According to Gallup, a global analytics and advice firm, businesses that scored the highest on employee engagement showed 21% higher levels of profitability than units in the lowest quartile. Companies with highly engaged workforces also scored 17% higher on productivity.

Given organisations with the most engaged employees experience more productivity and higher customer engagement, the benefits of ESOPs can soon outweigh the costs of creating and managing such a scheme.

Where do you start?

Create a realistic equity plan

Step one of setting up an ESOP is deciding on your plan objectives, like creating an ownership mentality for employees or supporting retention goals.

Afterwards, the optimum type of ESOP needs to be selected. Common ESOPs, such as Call Option plans (often called Employee Share Option Plans), Loan-to-Purchase schemes and Phantom Share schemes, can appeal to different companies depending on their size, structure and maturity.

Choose the best type of ESOP for your company

Choose which type of ESOP is right for your company by consulting an ESOP options guide. Secondly, talk to your professional advisors, such as lawyers or accountants, to ensure you select the best plan for your company.

After deciding on an approach, an ESOP pool (amount of shares available to employees) can be allocated. The pool typically sits around 5-15% of the total shares in the company. Decision makers can use an ESOP allocation tool template to model how much to grant to employees and how that would affect (dilute) existing shareholders.

Factors that affect ESOP allocation

There are several factors to consider, depending on your objective, when deciding how to allocate shares to employees, including the following.

Size of the ESOP pool

Each option pool should have the goal of setting aside enough equity to retain and hire the people your company needs before the next round of funding. So a company should plan for who they are hiring and how much allocated stock they would need to award them.

Employee's seniority and job function

Once an ESOP pool has been created, a company can select which employees to invite to participate in the scheme. Some companies reserve allocations for top-tier positions, while others opt to give all their employees some equity.

The stage of the company

The skill sets of the current staff will also influence the number of shares to employees. A smaller option pool for additional staff may be needed if there is a good team with existing equity. However, if the need for growth requires the company to hire many employees, a bigger pool than a standard 10% pool may be necessary.

Process of allocating ESOP shares

When the time comes to allocate ESOP shares with your staff, there are four main steps.

Identify a tier allocation for different levels

Ideally, you want three or four clearly defined tiers to determine the allocation of shares, where every employee understands which tier they fall into, and there isn’t a case-by-case negotiation. This saves admin time while keeping things fair and transparent.

Use a template for calculating ESOP pools and an ESOP allocation formula for staff

Once an ESOP pool has been created, companies can decide which employees to invite to participate in the scheme. Some companies reserve allocations for top-tier positions, while others opt to give all their employees some equity. As a general guide, employees at the same level should be offered the same range of shares. Here is an example of a commonly used structure that assumes all staff are earning a relatively equal market salary:

Always have a buffer

Your hiring plan may change. You may need to offer a bigger signing bonus than anticipated. There are many reasons you should include a buffer in your ESOP pool. The buffer can be a manageable size but should allow you some room for manoeuvre, 1-2% is usually enough.

In summary

ESOPs benefit employers and employees, encouraging more significant effort and commitment in exchange for financial compensation. Although, they are not always simple and can cause frustration if the employee doesn’t fully understand the terms of their plan.

Not all ESOPs are the same. Rules on actions such as vesting and withdrawals can vary, and it’s essential to be aware of them when choosing ESOP management software for your company.

For help in making the right choice for your company, contact Orchestra today.

Related articles:

For more information on the topics covered, go to;

• Understanding ESOP and Other Forms of Employee Ownership
• Receiving employee share scheme (ESS) benefits

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