In this post of our series on ESOP myths, we discuss the concerns about the safety of ESOPs for companies and their shareholders. It comes as no surprise that this, too, is merely a myth. ESOPs can encompass enforceable rules and additional mechanisms to ensure their proper functioning and enforceability, making them safe for all parties involved.
The decision to implement an ESOP is based on the assumption that a high degree of mutual trust between managers and the founder exists. This is particularly true in cases where managers directly acquire interests or shares in the company. Naturally, this gives rise to concerns for founders – what if the ESOP fails, relationships deteriorate, or insurmountable conflicts arise within previously harmonious relationships?
These concerns then give rise to the myth that ESOPs are not safe. They can be relevant both in relation to founders and other shareholders – could mutual trust be betrayed to the detriment of all involved by violating various rules?
However, reality can be different, and in this regard, the ability to set up an ESOP broadly while ensuring the safety and protection of all parties involved plays a crucial role. One of the key elements is establishing enforceable rules that define the specific rights and obligations of all parties. With these rights and obligations, it is, of course, possible to associate predefined penalties for their violation.
Different forms of ESOPs allow for varying levels of risk management for all parties involved. The crucial point here is to carefully agree on the rules first and then ensure that they are transparent and properly explained to all parties involved. Complying with the established rules subsequently allows for minimizing the risks associated with ESOPs.
It is not uncommon for ESOPs to often implement penalty mechanisms to enforce rules and protect the interests of all participants. These mechanisms typically include penalties for individuals who violate ESOP rules, with the most common example being the obligation to sell shares at a “penalty” price under the so-called “bad leaver” clause. This clause ensures that if a predefined situation occurs and a shareholder parts ways with the company on bad terms, he must sell his acquired interest or shares under unfavourable conditions. The key here is to initially set clear rules for when a “bad leaver” situation arises. Additionally, various institutes with associated penalties, such as dispute resolution rules, can be established.
Another factor ensuring the safety of an ESOP is the careful monitoring and management of the ESOP itself, for example, through regular reviews or audits. The golden rule applies here: the best problems are those that never arise. To combat most problems, besides correctly setting up an ESOP at the outset, also subsequent adjustments and refinements can be made in line with the company’s development. Along with the tools mentioned, another tool is, for example, the possibility to implement monitoring as to how an ESOP and individual participants perform. This allows for identifying and resolving potential problems in time, as well as possibly streamlining the entire ESOP.
At HAVEL & PARTNERS, we have wealth of experience in setting up all these aspects. We can provide you with sufficient support to dispel your concerns about the (un)safety of ESOPs.
