There are many things to consider as you set up your employee stock options plan. This guide will help you understand the basics of an ESOP and how you should go about establishing one for your startup.
What is an Employee Stock Option Plan?
Let’s start by reviewing the basics of an employee stock option plan, or an ESOP. Employee stock option plans are a type of incentive compensation that allows individuals the option to buy ownership in the company. The shares of stock are not granted directly, but rather, employees are allowed to buy shares at a specified price for a specific period.
The employee stock options agreement will clearly outline how many shares an individual will be eligible to buy, and at what price. It will also tell you when you have the option to purchase the shares. Generally, employees are not eligible to exercise their right to buy the shares until they are fully vested.
So, what are the benefits of creating an employee stock option plan for your organization?The main reason why your company might want to implement an ESOP include: attracting talent, reducing churn, rewarding high performers, and promoting long-term thinking.
One of the most common reasons for a startup to develop an ESOP is to attract the top talent in the industry. They may not always be able to compensate employees the way that large, more established corporations might - so this allows them to bring on people who are interested in owning a stake in the company.
When you promise an employee a piece of the company's future, you also motivate them to perform well as that will directly contribute to the money in their pocket.
High employee turnover can be very costly for a startup. Not only do you have to spend money hiring and training new employees, but you also lose the knowledge that those individuals developed when they leave.
Establishing an ESOP as part of your compensation package can help you reduce employee churn. Startups have one of the highest rates of attrition, but introducing an employee stock option plan encourages employees to stick around longer.
The idea is that if they stay long enough to be vested in the stock options, they will already be invested in the success of this startup and will be more likely to stay.
Reward High Performers
ESOPs are also a great tool to reward high performers, especially at the beginning stages of your startup.
For example, cash flow is one of the biggest hurdles that new companies face when they are trying to get off the ground. Thus, instead of using a cash-based reward, employee stock option plans offer an alternative way to reward those key individuals that create the most value.
Promote Long-Term Thinking
Another benefit of an employee stock option plan is that it helps you promote long-term thinking. When your employees and cofounders are invested in the company, your goals are aligned and they want the organization to be successful.
Most plans require at least 2 to 3 years of service before stock options are vested, so it also prevents employees from sacrificing the long-term potential for a short-term gain. They need to do what’s best for the company to increase the value of the stock options!
Before we get into how you can set up your stock option plan, let’s go over some basic ESOP terminology.
Vesting is a very important term when it comes to employee stock options plans, as it determines when the employee owns 100% of the options. It describes when you are eligible to keep your options since you will not get all of them upfront.
The company wants you to stay as long as possible, so you need to wait before you completely earn them. The vesting schedule will describe how long you need to remain employed to become fully vested, and this tends to take several years.
Depending on the specific vesting schedule, you may receive stock options incrementally during your employment.
The exercise price of the stock options defines the amount you need to pay to buy a share of the company. This price is predetermined in the employee stock option plan, and the idea is that it will be lower than what it is trading for on the market.
This term can also be called the strike price. Exercising your options simply refers to buying the shares that you’re allowed to purchase.
The grant date refers to when your employer gives you the option to buy a specified number of shares. It is important to note that employee stock options expire, so be sure to exercise them before the expiration date.
As you grant additional stock options to your employees, you are increasing the amount of equity available in the company. This reduces the ownership percentage of existing shareholders and causes a dilutive effect on their rights.
When to Issue the ESOP
The next thing you need to consider is when to issue your ESOP. The answer to this will vary depending on what stage your startup is in.
An employee stock option plan is not required at the pre-seed stage, but it is vital to measure how much equity you are giving away early on. During this phase, you will likely be giving key employees stock options on an as-needed basis.
Although any ESOP is not necessary during seed rounds and investors will generally not require it, establishing one can ensure that seed investors share the equity dilution later on.
Early VC rounds
It is essential to establish an ESOP during the early venture capital rounds since investors will require it, and new hires will be looking for this type of compensation as a reason to join your company.
Late VC rounds
As you get into the later venture capital rounds, you should have an established employee stock option plan with standardized procedures in place.
After your startup has moved past the financing rounds and enters the growth stage, the ESOP will likely be mostly exhausted at this point. However, use the remaining shares to incentivize new hires since they are now more valuable!
How to Structure an ESOP
When you start to structure your employee stock option plan, there are various things to consider, such as how much equity you will set aside and how you will allocate tiers.
Choosing the Right Amount of Equity
The first thing that you need to decide is how much equity will be available for stock options. Your founders will have a set stake in the startup, but the first people you hire after them will be expecting compensation based on their contribution.
A common practice revolves around 15% of the startup's total equity. Generally, you might reserve 10% of the stock options for the first ten founding employees that are very hard to replace. After that, the remaining 5% of equity goes to the next set of hires. They are the ones that will help scale the company.
Once the company is up and running, you can allocate an additional percentage each year from the current equity pool. Just note that this can lead to dilution for existing shareholders!
The next step is to create three or four clearly defined ESOP tiers that let employees know where they stand regarding ESOP eligibility. Tiers encourage transparency and will save you time when it comes to employee negotiations.
Here are some examples of ESOP tiers:
- Executives: C-Suite Employees
- Seniors: Experienced hires with management roles
- Juniors: Individual contributors
After the tiers are defined, you can determine what percentage of equity they are eligible for based on your business phase. For instance, during Series A funding the executive tier may get 10% of the options, while seniors are eligible for 1%.
Keep in mind that setting up the tiers properly will help you attract the right talent in each category.
Implementing Specific Terms When Employees Leave
Your startup should also take the time to implement specific terms for good-leavers and bad-leavers.
A good leaver is someone that retains their vested stock options and returns the unvested portion. These individuals leave the startup to advance their careers elsewhere, spend more time with family, or have other valid reasons for leaving the company.
When this is the case, your startup should have a call option in place that allows you to buy back the vested options when they leave. This allows you to refill the ESOP pool and distribute those options to new employees.
Bad leavers, on the other hand, are fired. This might be because of misconduct like fraud or a non-compete violation. These individuals must return all of their stock options, whether they are vested or not, without any compensation or substitution.
Recent trends in Europe have shown a shift in regulation, aimed at making the EU legislative environment more startup-friendly.
Changes are taking place in larger EU economies such as France, where incumbent president Emannuel Macron announced the introduction of a new tax system for ESOPs in January 2021. The move is aimed to make the EU more attractive to employees, and to rival the US in the search for talented hires.
Likewise, the Baltics are a great example of what can happen when you set up employee stock options the right way. They revised their legislation, and now they have some of the most favorable stock option policies in the world. As a result, they are now rated as one of the top places for startups.