A quick search of the web brings up many tales of employees who have become millionaires through an Employee Share Option Plan (ESOP) so you may not be surprised if employees come to you asking for one. ESOPs are a popular way of attracting, motivating and retaining employees particularly if a company is not able to pay high salaries or offer other benefits. Some ESOPs may even contribute cash to a company when an employee pays the exercise price for their option.
Why would I use an ESOP?
The most common reasons a company will use an ESOP are to:
• attract and retain talented employees;
• nurture a sense of loyalty among employees;
• implement an employee benefit plan without having to provide additional cash compensation;
• attract employees which might otherwise be drawn to larger organisations.
What are the downsides I should know about?
For employees, they will hold share options in a private company and this means a lack of liquidity – especially when compared to cash bonuses or receiving a higher salary. Unless your company is sold or creates a public market (e.g. lists its securities on an exchange), an ESOP will not be comparable to cash benefits. The company must grow and its shares increase in value for the options to be worthwhile for employees.
How does it work?
An ESOP gives an employee the right to acquire ordinary shares in the company at a specified exercise price which is fixed at the time the option is granted to them. So, an employee who is granted options at an early stage in the life of the company is likely to see a lower exercise price than an employee who is granted their options when the company is more established.
An example of an ESOP grant looks like this:
• Employee is granted options to acquire 1,000 ordinary shares in a company at USD0.01 per share.
• If the employee continues to be employed by the company, those options vest (i.e. are earned) over a four-year period.
• The ESOP includes a one year “cliff” i.e. the employee must complete one year of service before any of the options vest.
• At the end of the first year of service, 25% of the options vest to the employee.
• If the employee remains employed for the full four-year period, the employee may exercise all of their 1,000 options at the exercise price.
• Depending on the laws of the jurisdiction in which the company is incorporated, the exercise price will be either the fair market value at the time the employee is granted the options or simply a nominal sum (e.g. USD0.01).
• The employee must pay the exercise price x the number of shares (i.e. USD0.01 x 4,000, being USD4.00).
What do I need to know before I put an ESOP in place?
As a founder, you will want to ensure your ESOP gives your company flexibility to adapt to its growth and development. You’ll need to give some thought to the following:
• How many shares? An ESOP will set aside a maximum number of shares to be issued under the plan. The total number of shares usually ranges from 5% to 20% of the company’s authorised shares.
• How many options per employee? This is entirely negotiable but you may wish to set some internal policies so that roles within your company of similar seniority receive the same amount of options in the company. It is not the number of options that is important but what percentage of the fully diluted authorised shares that number represents. For example, if your company awards 10,000 options and there are 10 million authorised shares, the options represent 1% of the company. If you award 10,000 options and there are only 100,000 authorised shares, those options would represent 10% of the company.
• How will the options vest to employees? A vesting schedule sets out the period of time during which the employee continues to work for the company before their options vest (i.e. the employee has “earned” those options). For example, 25% of the options vest after the first full year of employment and the remaining 75% vest monthly or quarterly over the next 36 months.
• How much will the exercise price be? The amount an employee pays when he or she exercises their option is usually the fair market value of the shares at the time the option is granted to them. So, if the value of your company’s shares increases, the option becomes more valuable as the employee can buy shares at a cheaper price.
• How will the employees pay when they exercise their options? There are many ways this can be done and your ESOP should give full flexibility to your board of directors (and committee) to determine how the exercise price can be paid. Examples include cash, deferred payment, promissory notes or shares. Some startups use a cashless feature where an employee uses the accumulated value of their option (i.e. the difference between the exercise price and the shares’ fair market value) as the currency to exercise the option.
• When can employees exercise their options? ESOPs commonly include a sunset date, before which an employee’s option must be exercised. ESOPs typically provide for 30 – 90 days for an employee to exercise their option after their employment has terminated.
• How will you administer the ESOP? The board of directors is usually appointed as the administrator of the plan but as the company grows you may consider permitting the board to delegate some of the functions to a committee to allow maximum flexibility. The committee will need broad discretion as to whom it may grant the options to, the types of options that are granted and other terms of the options.
• Can I still terminate employment? The terms of your ESOP should state that the granting of the share options does not provide any guarantee of a continued employment relationship with your company.
• Do you only want a small number of shareholders? Consider including a right of first refusal. When the option is exercised, the shareholder gives the company a right of first refusal on transfers of those shares.
• Will your ESOP comply with any applicable securities laws? Putting an ESOP in place and granting shares thereunder will require compliance with certain securities laws. Your lawyer can help you navigate any applicable requirements.