For any (early stage) startup, the team is the most important asset. One of the most effective ways to build a highly motivated team and solid work culture is with an employee stock option program, also known as ESOP.
As tons of startup pivots have proven your co-founders and employees are even more important than your product. You can always change your product or business model or the region you are operating in, but changing your team is not as easy.
A number of great guides and benchmark reports have been written by venture capital firms like Balderton and Index Ventures. I have collected them at the end of this blog post. This article is about the basic structures of ESOP programs and what to consider when setting up one for the first time.
What is an ESOP?
An ESOP is a type of call option plan made available to employees of a company. It basically involves promising your employees a certain amount of company shares at a fixed rate/price (called the strike price or exercise price) after a vesting period.
The vesting period is the duration in which the employee accrues stock options but does not have the right to buy it. After the vesting period, the option is said to have been vested, and the employee can invoke his right to buy his accumulated stock option at the exercise price.
As a call option plan, employees are not obligated to purchase the shares. But you must provide it, whenever they exercise their right to buy the shares (provided it has been vested).
Typically, the employer sets up an ESOP trust, where he contributes to the company’s shares over time – to be sold to an employee after his options have been vested – at the exercise price. An employee stock option plan is solidified with a contract. With the terms set by you, the employer – as guided by the law.
ESOP plans have ever since gained favor with startup founders, because of the significant dedication it inspires in the workers. As startups with great employee stock option plans have proven to be much more productive than ones without it.
Benefits of ESOP to Startups
No doubt, a great team is the driver of any successful startup. That’s why it is always worth it to create a great work culture that will keep your employees focused, innovative and loyal to the company’s vision. Therefore, employee stock option plans provide a number of benefits:
1. Attract and Motivate Employees or Co-Founders
As startups are not able to compensate their workers as competitively as established corporations, employees can be attracted by getting a stake in the company. It also helps to attract founding team members who are not co-founder. ESOPs give them the needed piece of ownership of the company. They might also be used to attract board members or other partners helping to grow the company.
By promising your employees or co-founders a stake in the company’s future, they can align their interests with that of the company easily. They know that by doing more than required, they are contributing significantly to their pocket as well.
As a startup founder, this is the primary benefit for your company. The ESOP translates to increased productivity for your startup. Your drive becomes their drive. And with proper management in place, you will exponentially increase your efficiency, as you will more often be on the same page with the staff.
2. Reduce Employee Churn Rate
Startup employees are most likely to change jobs. However, with an ESOP in place, founders have found that the rate of attrition (or churn rate) has reduced significantly. The reason is quite apparent. The vesting period (see below) also creates a timeline goal in the mind of the worker – giving him enough time to become invested in the startup’s culture.
3. Reward Value Creation
As cash is king especially in the early days of your startup ESOPs can be a good (and cash preserving) way to reward your key employees for creating value. I am personally convinced that paying one-time bonusses does not reflect the value of creating lasting impact for the company´s future.
4. Encourage Long Term Thinking
ESOPs let your team share in the upside of the company valuation. As they come with a vesting period and an in the course of time increasing company valuation ESOPs encourage employees to think long term. It’s not a short-term bonus that can easily be spent for your next vacation trip. Instead it fosters an entrepreneurial behavior and an incentive to do what is best for the company in the long run.
Best Practices for ESOP Structuring for Early Stage Startups
ESOPs can create a win-win agreement between employers and employees. Sticking to the basics, we will explore some custom setups for early-stage startups.
1. Set the right equity for an esop
Founding partners have a set equity stake in a startup. Hence, they do not need to participate in the Employee Stock Option Program. However, your first few hires who play a significant role would expect compensation that reflects their contribution.
Many sources argue what exact percentage of the equity should be set aside to the ESOP. The most common practice, however, revolves around 15% of the total equity. Checking out the collection of further readings at the bottom of this post will give you lots of additional hints and opinions on how a good structure looks like.
This number is not set in stone as most startups do not have a linear path to their growth. The number is usually spread in the following manner.
- About 10% for the first ten founding employees. This includes key engineers and developers with functional roles that are hard to replace
- About 5% for the next 20% hires, including additional hands that help with scaling the company and meeting set schedules.
- For the next hires, especially after the company has grown substantially; many companies elect to allocate a certain percentage each year from the current equity pool. However, this leads to the dilution of the shares held by the existing shareholders.
2. Choose the right esop plan
There are different approaches to employee stock option programs. Each with its benefit and drawbacks to your startup. More common plans include:
A. Employee Stock Option Plan (ESOP)
A more or less standard employee stock option plan provides employees the option to purchase the company’s stock at the fixed strike price. Once the vesting period is over the employee is entitled to purchase shares in the company and would hold real equity.
Whether or no those shares will hold voting rights or not depends on the individual case. The overall goal of implementing an ESOP plan is to create a tool for the management to attract, retain and reward key staff members economically. In the most cases I have seen there are no voting or other rights attached to those shares.
The idea of stock options works specifically well with companies listed at a stock exchange. Exercising an option to buy the stock at a certain (hopefully lower than market) price results in an immediate gain and you can sell the stock at a higher price the same moment. This prevents a massive cash outlay in the first step and also provides liquidity for covering income tax payments resulting from the capital gain.
With private companies (espec.) in Germany (e.g. GmbH) it would definitely cause a lot of administrative hustle, since those contracts have to go through the notary and have a lot of implications on taxation issues. With shares not being publicly traded most employees would have difficulties to come up with the needed liquidity to first buy the shares, cover resulting income tax and then waiting for a chance to sell the stock later on.
Virtual stock option plans (VSOP) provide a viable option and providing the same benefits.
B. Virtual Stock Option Plan (VSOP)
A VSOP, also known as phantom stocks, is not really an option plan. Instead, it is a monetary compensation based on the value of the stock. It simulates an ESOP program thereby preventing all the problematic administrative and tax challenges.
It is an arrangement that obligates the employer to pay the employee an equivalent price to the value of phantom stock accumulated by the employee at a given time (usually after a defined event, e.g. exit).
Employees get rewarded with phantom stocks underlying the same terms as ESOP shares would have (e.g. Vesting, Exercise price etc.). These stocks are only virtual and cannot be converted into company shares, but its equivalent value in cash. The employer keeps the company’s equity, while the employee gets rewarded for helping to drive the company’s value.
At the time the options are exercised (e.g. at a defined liquidity event) the company owes the employee the cash equivalent, which is then paid out comparable to a bonus payment. For technical reasons it is important to keep in mind that this is a liability of the company towards its employees.
3. Determine the excercise price
At the time of the ESOP/VSOP contract, the agreed exercise price is called the strike price.
The primary benefit of ESOPs to employees is the difference between their exercise price and the fair market value after their vesting period is concluded. A good practice with exercise price is to keep it as low as possible relative to the current value of the total equity. The lower it is, the greater the profit margin for the employee when he exercises his option.
Strike Prices can vary quite a bit in startups. I have seen anything from nominal value (e.g. 1 EUR) to the price of the last financing round. Granting options with a strike price of 1 EUR to early employees might be fair while (from an investors perspective) it is also fair to set the exercise price to the share price from the latest financing round for employees joining the company around that time or after the round. The overall idea here would be to let employees share in the gains they helped to create.
Its important to understand that options are a margin business. That means holder of options benefit from the difference between current share price and their strike price. Furthermore, it has to be considered that every ESOP / VSOP program is (and needs to be) integrated with the existing liquidation preferences and the exit proceeds after transaction costs. These programs normally rank behind all liquidation preferences. When calculating the exit proceeds available for distribution to the shareholders the ESOP/VSOP transaction cost are deducted first and the net proceeds are distributed according to the exit waterfall.
4. Create a vesting schedule
The vesting schedule is the outline of the duration with which an employee garners his or her stock options until he can exercise his or her options. It begins when the ESOP contract has been drawn.
The custom is to spread accumulation of the agreed stock options amount over four years (sometimes three years, other times for longer duration). There is usually a cliff period, typically a year (part of the vesting schedule) where the employee does not accrue any option at all.
The employee gets the total shares he is entitled to over that year, all at once after the cliff period. That is, for a four-year vesting schedule; you get 25% of your total options after the one-year cliff period. The cliff serves as a trial period for the employee, to help the employer assess the employee’s capability and contributions to the company, before assigning him shares.
After the initial cliff the options then vest over the remaining three years.
A good chunk of the programs I have seen contain accelerated vesting clauses in case of exit event. Through such clauses all options become vested in the moment an exit event occurs. Good for the holder of the option not necessarily though for the buyer of the company. In this case the holder of the option can cash out his entire vested options and leave the company with (hopefully) a pile of cash. However, this might lead to a significant brain drain for the company. In a lot of transactions, the purchase price the buyers pay to acquire the company’s stock is at least partly dependent on certain milestones to be met in the coming years. Hence, it should be in the interest of shareholders to retain key employees and make sure that those milestones are met.
5. Implement a Good Leaver / Bad Leaver regime
Every program needs to consider what happens when employees leave the company within the vesting period and after the vesting has lapsed. You have to make sure that employees leaving the company return a part of their options to re-allocate them to new team members or the remaining staff. A good leaver / bad leaver regime has become absolute standard with some differences regarding the definition of what good leaver or bad leaver means.
Good leavers normally keep their vested options (and return the unvested portion). They leave the company for a good reason, such as changing jobs for career advancement or moving abroad with their families. Some programs also contain a call option on the vested shares for the company. The call option would allow the company to buy back the vested options in case the employee decides to leave. As long as the company has sufficient cash to do so this allows to manage the ESOP pool and distribute the options that have been bought back to new employees.
Bad leavers are normally fired from the company because of serious misconduct such as fraud or setting up a competing businesses. In that case all of his options – vested or not – are returned to the company without substitution or compensation.
6. Excercising stock options
Employees can exercise their stock options after the vesting period is over. The vesting period of four years was initially popular because it was the average time it took the company to become profitable, with its shares increased in value. These days, it takes longer for these to happen so, most employees stick around with their stock options till a major event occurs, such as an IPO (Initial Public Offering) or a sale of the company.
In virtual stock option programs options are not said to be exercised. Instead the holder of the option holds a claim against the company in case one of the defined liquidity events occurs.
These events usually come with an increased valuation of the company.
7. No dilution protection
It needs to be mentioned that ESOP/VSOP plans are most commonly not protected against dilution in case of further financing rounds. In that sense the ESOP pool is treated as any other shareholder in the company.
That means (just to be clear) that those plans refer to a number of options (shares) not a certain share of the exit proceeds. If you grant someone a certain share (e.g. 2%) of the exit proceeds this would be totally independent from the ownership position in the company. What a great deal would that be, if one could claim 2% of the exit proceeds with having only 0,05% ownership position.
If the company issues new stock to investors the size of the plan (number of options) is not increased automatically. This leads to dilution. In early stage startups and in venture capital backed companies in general its quite common that the program is kept at a certain level over the course of several rounds of financing. So, it`s filled up after each round. The economic burden is shared between the founders and the investors. However, this is not a given and needs to be negotiated in every round. The exception from that might be something like stock splits and other “internal” measures of financing.
8. Communication ESOP program / allotment letter
If you have never heard of terms like vesting or strike price ESOPs are not easy to understand. It’s the responsibility of the founders (or the board) to sit down with their team to explain things before handing out an allotment letter. An allotment letter is a document defining all the terms described above for the individual employee. It specifies the number of options, the begin of the vesting period and all the other components. Attached to the individual allotment offer are the general plan terms.
Without proper explanation employees can neither understand nor value the options they are about to receive. The portion of the ESOP granted to each individual employee is often communicated as a percentage of ownership in the company (e.g. 1% of the company) which needs to be put in perspective with existing liquidation preferences and potential dilution going forward. Think about expressing the value of the option based on the last share price to clear things up.
9. Best practives when managing ESOP programs
Such programs can be quite complex and the challenge is to keep things orderly over the course of several years and financing rounds. Beyond what is already written above here are some tips and tricks you might want to consider when setting up and managing your ESOP program:
- No-Brainer: Consult with your lawyer, tax consultant, your board and your investors how to implement a well-structured plan. Consider all aspects that might come up in the future, e.g. new rounds of financing, exponential growth or exit among others.
- Don´t use options in ad-hoc recruiting situations but rather create a structured program from the beginning. Think twice which roles are really mission critical and needs to be rewarded by granting them ownership in the company.
- Create a consistent scheme how much to grant to the different roles (see further readings for more input). A “percentage of salary” thinking might be a good starting point. Keep reserves!
- Super important and highly underestimated: Keep records and documentation on your plan, allocations, contact data (!) of employees leaving the company. You will need those data when exiting the company. Have an overview of allotments, vesting schedule etc. at hand at any point in time.
Collection of Useful Links for ESOP
While this article has been written to shed light on ESOPs, you will need more help when trying to implement it. This collection of links should be a good starting point to learn more about ESOP and its best practices:
- The Balderton Essential Guide To Employee Equity
This is a great summary of learnings and policies conducted by one of Europes` to venture capital companies. It also points out differences across regions and provides some guidance on how much equity should be given to which roles.
- Fred Wilsons Blog (AVC)
He wrote a great series on Employee Equity. Although its been back in fall 2010 it still is a very good point to start from.
- ACCION Guide on Employee Equity
A very comprehensive guide on ESOP best practices an guidelines for structuring your ESOP program.
- Index Ventures guideline on Rewarding Talent
One of the best know venture capital firms worldwide shares its experience on how to reward employees in startups using ESOP.