A share option plan is commonly used by companies to attract, reward, and retain talents, typically their employees. It is commonly known as "ESOP" (Employee Share Option Plan). It allows eligible employees to buy a defined number of shares at a fixed price known as the exercise price. These employees will benefit from the increase in value of the company by exercising their option to buy shares when the shares are trading at a price greater than the exercise price.
What is a share option?
A share option is not a share; it is a right to acquire shares when it is exercised. Share options are usually "vested" over time or upon fulfilling certain conditions (e.g. performance targets), meaning that the option holder becomes able to exercise the right and acquire shares in the company.
Step 1: Adopting a share option plan
Firstly, the company adopts a Share Option Plan that establishes the general rules under which the board will grant the options. The Share Option Plan typically sets out the purpose of the plan (e.g. to incentivise employees), who will be eligible to participate in the plan (e.g. employees of all levels or a certain level or above) and, most importantly, the overall size of the pool of shares that the option holders will be entitled to buy. The Share Option Plan also generally sets out how to grant an option, how to exercise an option granted, and what happens when the option holder leaves the company or dies.
You must note that a Share Option Plan only sets out the rules on how the options will operate; it does not give any right to any individuals participating in the plan.
Step 2: Granting options
Following the adoption of the Share Option Plan, the company may now grant options to individuals by issuing Option Certificates. Each Option Certificate sets out the specific terms of grant for each individual, including the total number of shares to be purchased upon full exercise of the option, the exercise price, the exercise condition (if any), and the date (or dates) on which the option becomes exercisable (i.e. the vesting date (or dates if applicable)).
Step 3: Exercising share options
Once the option granted under the Option Certificate becomes exercisable, the option holder may exercise that right, i.e. to proceed with the purchase of the shares by giving a notice to exercise the option. A standard form of this notice is provided in the Letter for Grant of Option. The notice to exercise the option must enclose payment for the shares to be purchased.
It is important to note that the Option Certificate also specifies the date until which the option can be exercised. After this date, the option will lapse and it can no longer be exercised (i.e. the option holder can no longer purchase shares at the specified exercise price).
If an option holder leaves the company, the part of option which has not been exercised can no longer be exercised.
Step 4: Issue of shares upon exercise of option
Following a valid exercise of share option, the company secretary will issue and allot shares to the individual purchasing the shares, and that individual will become a shareholder of the company.
As proof of ownership of the shares, a Share Certificate will be issued to the individual.
A share option is a very common way of rewarding employees, but it is not the only way. Check out how a Share Vesting Agreement works and what the difference between share option and share vesting is.