Why ESOP Trust for Pre-IPO Companies?

17 July 2020
In recent years with the overseas IPO fever among Chinese companies, in addition to Pre-IPO private family trusts for individual shareholders in pursuit of succession planning more and more Chinese companies also tend to establish an Employee Share Ownership/Option Plan (ESOP) Trust to implement their share award schemes for their employees.

In recent years with the overseas IPO fever among Chinese companies, in addition to Pre-IPO private family trusts for individual shareholders in pursuit of succession planning more and more Chinese companies also tend to establish an Employee Share Ownership/Option Plan (ESOP) Trust to implement their share award schemes for their employees.

Why is an ESOP Trust popular among Pre-IPO companies in China? 

During the process of corporate restructuring for overseas IPO, quite a few Chinese companies, especially those in technology, media and telecommunications (TMT), and biotech industries that value their staff as the core assets, usually spare part of the shares of the Cayman entity (listing in future) as an ESOP pool that is implemented under a share award scheme.

Before the IPO, the company for various reasons might need to update it’ share award scheme as well as the list of ESOP participants, which might make part of the restricted shares or share options vest in some ESOP participants. Once the restricted shares or share options vest in an ESOP participant, he or she will have right to become a shareholder by exercising the option, which is not what an employer actually expects especially before the IPO in that an employee who becomes a shareholder might not be as motivated as before and he or she will still be a shareholder in spite of his or her resignation as “a bad leaver” who joins a competitor.

Under such a circumstance, it might be a perfect solution for the company to establish an ESOP Trust to house the restricted shares or share options granted or ungranted for the benefit of the ESOP participants. An ESOP Trust, dose not only offer the company flexibility to revise the rules (to some degree) such as the timing to vest or distribute, scenarios to reallocate the restricted shares or share options, etc., but also helps the company effectively retain their talents until they can conditionally become shareholders after a six-month lock-up period after the IPO.

The essential roles in an ESOP Trust include but not limited to:

  • Settlor: The Pre-IPO entity that grants restricted shares or share options to employees or an ESOP Trust
  • Trustee: A licensed trust company that hold the restricted shares or share options entitled to the participants/beneficiaries
  • Beneficiaries: Employees who participate in an ESOP Trust
  • Advisory Committee:

According to different needs of different companies, an ESOP Trust can have bespoke roles for bespoke functions.

By directors’ resolutions, the Cayman company establishes an ESOP Trust that will set up a Trustee-Managed Entity (usually a BVI company wholly owned and controlled by a licensed Trustee) to receive the restricted shares or share options from employees or the Cayman company. There are two common practices of asset injection for an ESOP Trust:

one practice is that the company requests their employees (who participates in the ESOP Trust) to transfer and gift their shares to the ESOP Trust if they exercise the granted restricted shares or share options before IPO; the other practice is that the company’s Cayman entity directly issues shares to the ESOP Trust for the benefit of its employees who haven’t been granted anything.

To establish an effective and compliant ESOP Trust, the company needs to work with a professional team including its Chinese and overseas lawyers, tax advisor, trustee, trust lawyer and share award scheme composer, etc.

In an ESOP Trust, the Advisory Committee plays a significant role. The Advisory Committee that usually consists of the company’s staff of human resources and finance appointed by the Settlor via director’s resolution, by written instructions directs the Trustee for trust management matters including purchase or sale of the Trust’s underlying shares, asset distributions to beneficiaries, addition or deletion of beneficiaries, revision of Trust Deed, rules of distributions, etc. On the premise that the Trust Deed is linked to the company’s share award scheme, the Advisory Committee needs to give instructions in accordance with the share award scheme. Besides, to protect the interest of beneficiaries, the Trustee only exercises its powers for aforementioned trust management matters when there is no contradiction between the Advisory Committee’s instructions and the company’s share award scheme.

Normally, to avoid the unnecessary extra trouble of information disclosure to the SEC or the stock exchange (especially in the U.S.), the Advisory Committee members are not suggested to be any senior executive of the company who is disclosed publicly as a key management member or a principal shareholder.

The company, with one single or different share award schemes by granting restricted shares or share options, may offer ESOP benefits to different groups of employees, ordinary employees, or key senior executives. If the company establishes one single ESOP Trust for the benefits of different groups of employees who have been granted different classes of assets (e.g. restricted shares and share options) under different vesting rules, there might be inconveniences and delay for the Trustee to make distributions as it’s challenging and time consuming for calculation and reallocation of the proportion of the Trust assets.

For instance, once some employee beneficiaries are removed from the ESOP Trust due to their unfulfillment of the requirements in share award scheme or resignation or retirement, the remained shares or share options of different classes that haven’t distributed to these excluded beneficiaries might need to be reallocated by the Trustee to new beneficiaries in accordance with the Advisory Committee’s instructions.

The Trustee, within the remained assets in the ESOP Trust, need to confirm with the Advisory Committee on the specific class of assets to be reallocated to the different groups of new beneficiaries. In a big company with a large number of employees, it is common that the ESOP participants/beneficiaries under different share award schemes are changed from time to time, which usually causes inconveniences and inefficiency for the company to implement their share award schemes with one single ESOP Trust.

Therefore, it will be more convenient and efficient for the company to establish different ESOP Trusts to implement different share award schemes for different groups of employees, which makes it much easier for the Trustee as well.

When an ESOP Trust is established, it is usually essential to open a securities account for the Trust’s underlying Trustee-Managed-Entity and each beneficiary respectively to hold the future listed shares for distributing, selling or pledging. The shares can be distributed to the beneficiaries’ personal accounts, or their wholly owned and controlled holding companies, or private family trusts.

If beneficiaries need to exchange their received cashed-out assets from overseas to China, it is required for the company to file Circular No. 7 under State Administration of Foreign Exchange in China for the approval to open an RMB ESOP bank account with the operating entity in Chinese Mainland for receipt of the overseas cash from the ESOP Trust and future distributions in China.

In a nutshell, an ESOP Trust can benefit both the employer and its employees as a win-win solution. For the employer, an ESOP Trust provides a safe and flexible platform to implement the share award schemes to encourage and retain the talents, which can also save the costs of time and human capital for administration. For the employees, on one hand, an ESOP Trust can motivate the employees by the independent structure and transparent rules, which minimizes the conflicts between shareholders of the employer and the employees; on the other hand, under some specific circumstance, an ESOP Trust may also bring some tax benefits to the ESOP participants from China individual income tax perspective.


Disclaimer: This article does not provide any formal suggestions or legal or tax advice.