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What’s the deal with ESOPs?

This article is not intended to serve as be legal or financial advice. A significant decision like setting up an ESOP requires considerable planning and legal advice for all parties involved—employees, advisors, founders, and investors.

ESOP = Employee Stock Option Plan. An ESOP is an employee benefit plan that enables employees to own part or all of the company they work for at fair market value.

You can think of stock in a startup like a slice of pie. You want that first slice- fresh and hot out of the oven. And that is where stock options come in, as they allow employees to own a “slice” before others.

Early-stage startups commonly use stock option plans to attract high-quality talent when the company cannot pay competitive salaries. Stock options can be part of a total compensation package and are an agreement between the employer and employee that gives the latter the right (but not obligation) to buy company shares in the future at a pre-set purchase price.

The Power of Employee Stock Option Plans for Startups

Startups often face fierce competition for talented individuals in the job market. ESOPs can be a game-changer in attracting and retaining skilled employees. By offering stock options, startups give their employees a direct stake in the company’s success. This incentive aligns the interests of employees with those of the company, motivating them to work harder and smarter to help the startup grow.

Stock options do not guarantee financial gain; they are an incentive if the company does well. It is imperative to note the risks of accepting stock options as part of a compensation package as an employee.

Advisor shares are also a stock option grant and typically fall in the same pool. Advisory shares can be beneficial as engaging with startup advisors is beneficial in the early stages. Providing advisor shares allows startups to offer non-cash equity compensation to advisors and consultants in exchange for their time, expertise, strategic insights, experience, and network.

Startups frequently operate with limited financial resources, making it challenging to offer competitive salaries. ESOPs provide a creative solution. Instead of relying solely on high wages, startups can offer stock options as part of the compensation package. This helps the company preserve cash and provides employees with the potential for significant financial gains as the company grows.

How do ESOPs Work?

Employee Stock Option Plans (ESOPs) are a form of compensation that allows employees to purchase a specific number of shares of their company’s stock at a predetermined price within a set period.

The shares that comprise an option pool are typically drawn from the company’s founder stock rather than the shares earmarked for investors. This may be 15%–25% of the overall outstanding shares and may be determined when the startup receives its earliest funding round as part of the overall terms put in place. The option pool grants shares that typically vest after a defined period of time.

When hiring an employee and offering an ESOP, an employee receives a stock option agreement that outlines the rights of both employee and employer regarding their stock options, including any vesting conditions or expiration dates associated with them.

Stock option agreements are legal documents that typically contain the following information:

  • Total number of shares granted
  • Type of options
  • Exercise price per share
  • Grant date
  • Vesting schedule
  • Termination period
  • Term of award/expiration date
  • Administration and exercise of the option
  • Other clauses and legalese on non-transferability of options, tax obligations, change in control, governing laws, etc.

A vesting schedule is simply a timeline or a set of conditions determining when an individual is entitled to the full ownership of said stock. Vesting schedules are critical for several reasons:

  1. Retention: They incentivize employees to stay with the company for a particular duration to receive the full benefit of their stock options or other incentives.
  2. Alignment of Interests: Vesting aligns the interests of employees with those of the company, as employees must contribute to the company’s success to fully realize the value of their options.
  3. Performance: It encourages employees to perform well and contribute to the company’s growth, as the value of their options is tied to the company’s success.

When employees become eligible to exercise their options, they can purchase the specified number of shares at the exercise price. They can choose to exercise some or all of their options. The exercise process usually involves:

  • Completing the necessary paperwork.
  • Paying for the shares at the exercise price.
  • Receiving actual stock ownership.

Once employees exercise their stock options, they become actual shareholders of the company. They may have voting rights and the potential to receive dividends and benefit from any company stock price increase. After acquiring the shares, employees can decide whether to hold onto them or sell them. The decision to sell may depend on various factors, such as their financial goals, tax implications, and the company’s performance.

If an employee leaves the company before their stock options fully vest, they typically forfeit any unvested options. Some ESOPs may have provisions for extended exercise periods for departing employees under specific circumstances.

When is the right time to set up an ESOP?

You should set up your Employee Stock Option Plan (ESOP) when you are in the early stages of growth. This is because having stock options at an early stage helps to attract and retain talent while also incentivizing employees to focus on long-term success.

It is commonly expected that venture capitalists will ask startups to crave one out if the startup still needs to set up an ESOP. It also signals to investors that you are ready and willing to go after the best talent to help build your business.

Owning a proverbial slice of the pie can be an exciting incentive to offer early employees of your startup. Employee Stock Option Plans are valuable for aligning employee interests with company success and fostering a sense of ownership. They can be a win-win for both employees and the company, providing employees with the potential for financial gain while helping startups attract and retain top talent.

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