In recent times, Startups have increasingly offered stocks as a valuable way of remunerating and motivating their employees to work towards achieving long-term corporate goals.
In 2021, it was reported that the Nigerian Exchange Group introduced equity-based incentives to its employees’ remuneration, including an Employee Share Ownership Plan. This article highlights the relevance of an Employee Stock Options Plan (“ESOP”) as a means of compensating founders and guaranteeing the commitment of key employees.
1. What is an ESOP?
An ESOP provides an employee a right to purchase a certain number of shares in a company at; no charge, a nominal value, or a price below the fair market value (“Exercise Price”) after a specified period of time, during the course of employment (“Grant Date” ).
2. Why should Startups Consider ESOPs?
Most Startups at their early stage require the best talents to succeed. At this stage, they are not likely to have sufficient capital to compensate those talents. By setting up an ESOP as a potential incentive, Startups will incur minimal expenditure on employee compensation while creating a sense of ownership.
For instance, an employee may be offered an annual remuneration of N10,000,000 (Ten Million Naira) but will only be paid N6,000,000 (Six Million Naira) in cash while the balance of N4,000,000 (Four Million Naira) will be compensated with stock options when the company’s value increases.
3. How are ESOPs Set up and Exercised?
A Startup may create a stock option pool at the inception of its business. In this case, the company issues and reserves a pool of shares for its employees, usually prior to an investment round. Oftentimes, investors prefer that the pool is reserved prior to fundraising as it provides some confidence that the founders/initial employees would remain committed to ensuring that the business achieves its long-term objectives.
ESOPs may be included in founders’ and employment agreements, stipulating the number of shares offered, Exercise Price, Grant Date and waiting period before the stock options become exercisable (“Cliff”). Generally, where an employee resigns during a Cliff, he forfeits his right to exercise the stock options. Furthermore, there are vesting provisions which provide a schedule on how the options will be awarded depending on the employee’s performance or the period he remains in employment.
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This also incentivizes the employee to continue in the Startup’s employment for a long period of time.
At the expiration of the Cliff, the employee may exercise the stock options by purchasing the shares at the Exercise Price as they vest, subject to the terms of the ESOP.
4. Tax Considerations for ESOPs
Under the provisions of the Personal Income Tax (Amendment) Act, all salaries, wages, allowances and other gains from employment, compensation and other benefits are subject to personal income tax. There is however no specific provision on treatment of taxation of stock options. On this basis, the Lagos State Internal Revenue Service (LIRS), in 2017 issued a notice mandating the payment of tax on employee shares or stock options. According to the notice, a gain will be deemed to have been made by an employee where it acquires stock at zero cost or a cost which is below the fair market value of the stock. In such cases, income tax will be assessed against the difference between the purchase price and the fair market value of the stock. In addition, dividends earned on the stock during the vesting period shall be subject to personal income tax.
It is not clear, however, how ESOPs will be treated in other states across Nigeria for the purpose of taxation.
ESOPs are beneficial to both employees and Startups when they are properly considered and structured. It is important that both employers and employees consider the tax and regulatory implications of setting up ESOPs, especially in instances where the stock is offered to employees by an affiliate company registered in other jurisdictions.