In the previous posts, we introduced the basics of the main options of employee stock ownership plans (ESOPs), namely the option without an equity interest, the option with an equity interest (and its sub-options), and the issue of different types of shares and their creation. It is now time to introduce the basic options for joining and leaving an ESOP. Of course, there are a variety of ways to initiate and terminate the manager's participation in the ESOP. Our ambition today is just to present the very basic cases of a manager's entering and leaving, including so-called options, which is a tool that will usually assist you to execute such entering or leaving.
At the outset, it is also appropriate to return to the earlier division of the different types of ESOPs. Today, we will again focus on the usually more sophisticated part of ESOPs - ESOPs with an equity interest.
Joining an ESOP
There can be many ways how a manager can join an ESOP. It always depends on what level of motivation and security provided the manager is comfortable with. It is, of course, possible to transfer all the target's shares in the company to the manager from day one, and thus involve him in the company's operations and shareholder decision-making about its future right from the very beginning of the ESOP. This will usually be the case when the company's owner is already convinced of the manager's qualities and contribution to the entire group, and therefore knows well, based on previous experience, that the manager has "earned" the equity interest.
However, it may also be the case that the manager is just joining the company from outside as a new person and the current owner of the company wishes to have this personnel acquisition motivated in the longer term. Then there is the option that both parties agree on certain conditions (e.g. a period of time worked for the group, meeting certain strict criteria, development of a specific new part of the business, etc.), only after the meeting of which the manager acquires the target share, or even just gets the opportunity to acquire it and it will be at his discretion when he will actually do so (the given period of time as a condition for acquiring shares is typically referred to as the vesting period).
Leaving an ESOP
Similarly, there are multiple ways how the manager can leave an ESOP. Typically, the original owner of the company, who lets the manager into its structure, has a much greater scope of powers when terminating the manager’s participation in the ESOP. However, in certain situations, the manager may also trigger the leaving process. Of course, it always depends on the agreement between the parties, but the rule is that the original owner will not usually want a dissatisfied manager who wants to leave the structure anyway.
However, the reason for the manager's leaving is not necessarily the manager's or owner's dissatisfaction. This may be the reaching of retirement age, the completion of a period of time in the company agreed by the parties, the achievement of a milestone so significant that the manager moves permanently to another position (e.g., permanently in a shareholder position, no longer a managerial position), etc.
The basic tool that will enable both parties to meet the above objectives are the so-called option rights. It is the entitlement of a party to demand something from the other, provided that the previously agreed conditions are met. Now we will distinguish between two basic options - a call option and a put option.
A call option will usually be associated with the purchase of shares. This is the right of a party to ask the other to purchase a share in the company. Such a right can flow in both directions, i.e. from the manager to the original owner - the manager has the right, after the vesting period has expired (or other conditions have been met), to require the original owner to finally transfer a certain target share to him (under what conditions we will discuss next), or to transfer a further portion of the share to him, as the ESOP is working according to the expectations of both and the manager is successfully meeting the previously set objectives and thus deserves a larger equity interest in the company.
However, a call option can (and usually will) also be vested to the original owner against the manager. This covers the original owner's possibility to terminate the ESOP at his discretion. In fact, under the agreed terms, the owner may want the manager to sell his share back to the owner (i.e., the owner will buy the share from the manager), which will usually result in the partial or complete termination of the manager's participation in the ESOP.
This may be due to a simple change in the original owner's idea of the person who should occupy a given managerial position in the group. However, it may also be because the manager has committed a specific unlawful act or other previously identified conduct that is detrimental to the entire group.
That is why a distinction is often made between so-called “good leavers” and “bad leavers”, i.e., cases where the manager leaves on good terms, or rather the opposite. This will also generally decide how much the manager will receive for the transferred share, whether any penalty will be applied to the purchase price (in the case of a bad leaver) and how profitable the entire ESOP is for him in the end.
A mirror alternative to a call option is a put option. It is already clear from this that in this case it is the right to sell one’s share to the chosen person. Typically, only the manager will have such right, as a safeguard that can be activated when the manager decides to leave the ESOP.
By analogy to a call option, a put option may also have previously agreed terms, where the manager can claim to sell his share and thus actually leave the group. Again, the terms will be to the satisfaction of both parties and will typically relate to years worked within the group. A put option (but as indicated, also a call option) can and usually will include a specific formula or procedure by which both parties obtain the purchase price for the transferred shares so that its amount is not questioned between the parties and thus future disputes do not arise.
After discussing entering and leaving the ESOP, there is only one thing left to do - discuss the tax basics of the entire process. You can look forward to those next time.