Introduction To Esop

This guide is designed to equip founders with the knowledge and tools to create an Employee Stock Option (ESO) plan that attracts top talent while maintaining control over their company. It will cover the following key aspects:

Benefits of ESOs

Attracting and retaining top talent: 

ESOs incentivize talented individuals to join your company by offering them the potential for significant financial rewards if the company succeeds. Owning a piece of the company can make talented employees feel more invested and committed to its success.

Imagine you’re a promising startup developing a revolutionary new app. Top talent in the tech industry is highly sought after, and offering competitive compensation packages is crucial. Including ESOs in your package shows potential hires the potential for significant future rewards if the company succeeds, making your offer more attractive compared to competitors who don’t offer equity.

Aligning employee interests with company success: 

When employees hold stock options, their financial well-being becomes tied to the company’s performance. This motivates them to work hard and contribute to the company’s success, as their financial gain is directly linked to it.

Let’s say the founder has a team of talented developers working on the founder’s app. By granting them ESOs, their financial success becomes directly tied to the company’s success. This incentivizes them to go the extra mile, put in their best work, and contribute to the company’s growth, ultimately benefiting both themselves and the company.

Motivating employees to go the extra mile: 

ESOs can act as a powerful motivator, encouraging employees to go above and beyond their regular duties. Knowing they have a stake in the company’s future can inspire them to take initiative, innovate, and contribute creatively to help the company achieve its goals.

Imagine a talented marketing manager who receives ESOs upon joining your company. Knowing that their hard work and contributions can translate into significant financial rewards in the future, they are more likely to be highly motivated to exceed expectations, develop innovative marketing strategies, and drive the company’s growth.

Elements of an ESO Plan: 

Pool size (total number of shares available for options): 

This determines the total number of shares that can be granted as options to employees. It’s a crucial decision, as it impacts both the potential benefits for employees and the level of dilution experienced by existing shareholders.

Think of the ESO pool as a pie, representing a portion of the company’s ownership. The pool size determines how much ownership is set aside to be distributed as options to employees.

Vesting schedule (duration for employees to earn ownership rights): 

This defines the timeframe over which employees gradually gain full ownership of their granted stock options. It incentivizes long-term commitment, as employees only fully own the shares after fulfilling the vesting period.

Imagine your marketing manager receives options for 1,000 shares, but they don’t become full owners immediately. A vesting schedule might dictate that they earn ownership rights to 250 shares every year for the next four years. This ensures continued commitment and incentivizes long-term employment.

Strike price (price employees pay to exercise options): 

This is the price at which employees have the right to buy the company shares associated with their options. It’s typically set at the fair market value of the company’s share when the option is granted. Employees can choose to exercise their options and purchase the shares at the strike price once they have vested and believe the market value of the shares is higher than the strike price, generating a potential profit.

This is the price employees pay per share to purchase the stock when they decide to exercise their options. Imagine the strike price is set at $1 per share, and the market value eventually rises to $10 per share. The employee can then pay $1 per share to acquire shares worth $10 each, generating significant profit.

Determining the Size of the ESO Pool: 

Company size and stage (startup, growth, mature): 

Startups typically offer a larger percentage of their ownership as ESOs to attract talent and incentivize them as the company grows. As companies mature, the ESO pool size may become smaller as the company has other established methods for attracting and retaining talent, and the focus might shift towards rewarding specific performance or roles.

Imagine one founder creating a promising AI startup. To attract the best engineers and data scientists, the founder might offer a larger ESO pool, say 20% of the total company shares. This significant upside potential incentivizes them to join founders with high-risk, high-reward ventures.

Fast forward a few years, and the founder AI startup is experiencing rapid growth. The founder might adjust the ESO pool size down to 10% as the founder have other established tools for attracting talent, and his/her company valuation has increased, making even a smaller pool valuable.

Industry standards and competitor offerings: 

Researching what other companies in your industry, especially your direct competitors, offer in terms of ESO pool size is crucial. You want to be competitive in your offer to attract top talent, but also avoid giving away an excessive portion of ownership compared to the industry standard.

Let’s say founder in the competitive social media space. Research shows that established social media companies typically offer ESO pools around 15% of total shares. To be competitive in attracting top talent, the founder might aim for a similar pool size or slightly higher (around 18%) to make your offer more enticing.

Budgetary constraints: 

The cost of the ESO pool needs to be factored into your overall budget. Granting options essentially reserve a portion of your company’s future value for employees. Balancing this against the founders’ immediate financial needs and future funding plans is important.

Imagine one startup that has limited funding for the next year. A large ESO pool could significantly impact your cash flow down the line if employees exercise their options and require startups to buy back shares. In this case, the founder might opt for a smaller pool size (around 5%) to manage costs while still offering some ownership potential.

Dilution impact on existing shareholders: 

Granting ESOs dilutes the ownership percentage of existing shareholders, including founders and investors. This means their ownership stake in the company is proportionally reduced. Finding the right balance between attracting talent and minimizing dilution is crucial.

Let’s say the founder offers a 20% ESO pool to attract talent. This dilutes the ownership of existing shareholders, including the founder. If the founder initially owned 50% of the company, ownership would decrease to 40% after granting ESOs. Finding a balance between attracting talent and keeping an ownership stake at a reasonable level (around 30-40%) is crucial.

Balancing Dilution with Long-Term Benefits

Utilize formulas and tools to estimate dilution: 

There are various formulas and online tools available to help founders estimate the dilution impact of different ESO pool sizes on existing shareholders. This allows founders to make informed decisions about the appropriate pool size based on your specific circumstances.

There are online ESO pool dilution calculators available. Founders can input company’s current valuation, number of outstanding shares, and desired pool size as a percentage. The calculator will estimate the dilution impact on existing shareholders. This allows founders to see how different pool sizes affect ownership percentages.

Consider offering a smaller pool with potential for top-ups (additional options): 

Instead of offering a large pool upfront, consider starting with a smaller pool that is still competitive in the market. founders can then implement a top-up program where founders grant additional options to employees based on achieving certain performance milestones or company goals. This allows founders to manage dilution while still offering the potential for significant rewards to employees.

Imagine Instead of offering a large 20% pool upfront, founder might start with a smaller, more manageable 10% pool. Founder can then implement a top-up program where employees who achieve specific performance goals (e.g., exceeding sales targets) or company milestones (e.g., reaching a certain user base) receive additional options. This allows founder to manage dilution initially and still incentivize outstanding performance.

How Many ESOs Should You Give to Employees? 

Determining the number of ESOs to grant an employee requires careful consideration of several factors:

Employee’s level and position within the company: 

Senior executives (CEO, CFO) and key personnel with specialized skills (e.g., lead engineer) typically receive a higher number of ESOs compared to entry-level employees or those in less critical roles. This reflects their greater impact on the company’s success and incentivizes them to remain committed for the long term.

Performance and contribution to the company: 

An exceptional salesperson who consistently exceeds quota might receive a higher number of ESOs compared to an average-performing salesperson. This rewards outstanding performance and motivates employees to go above and beyond their standard duties.

The market value of the company and individual shares: 

If a company is a well-established tech giant with a high market valuation per share, the founder might grant fewer ESOs per employee compared to a young startup with a lower valuation. This is because even a smaller number of shares from a high-value company can translate into significant future rewards for the employee.

Common Allocation Methods

Percentage of total pool: 

Founder could allocate a fixed percentage of the total ESO pool (e.g., 10%) to a specific department based on their overall contribution to the company. This ensures a fair distribution within the department and incentivizes collective performance.

Grant based on position and seniority: 

Founders could create tiers based on employee level (e.g., executive, manager, individual contributor) and assign a specific number of ESOs to each tier. This provides a clear structure and aligns grant size with the expected level of impact and responsibility.

Performance-based grants: 

Founder could implement a system where employees receive a base number of ESOs upon joining and become eligible for additional grants based on achieving specific performance targets. This directly links rewards to individual performance and motivates employees to excel.

MSOs, Top-Ups, Paperwork & Taxes: 

MSOs: 

These are options granted specifically to executives and key personnel, often with different terms than standard ESOs.

MSOs might have a longer vesting schedule (the time it takes for employees to earn ownership rights) or a lower strike price (the price they pay to purchase the shares) compared to standard ESOs. This reflects the higher level of responsibility and impact these individuals have on the company’s success.

ESO Top-Ups: 

This refers to granting additional options to employees beyond their initial grant.
Founders might offer top-ups to employees who consistently exceed performance goals or reach specific company milestones. This further incentivizes continued commitment and outstanding contributions.

Considerations for MSOs and Top-Ups: 

Alignment with overall equity strategy: 

Ensure MSOs and top-ups are aligned with your overall equity strategy and don’t disproportionately dilute the ownership of other shareholders, including founders and investors.

Potential impact on employee morale and fairness: 

Be mindful of how MSOs and top-ups affect employee morale. If not implemented fairly and transparently, they can create feelings of unfairness among other employees who don’t receive such benefits.

Paperwork and Records for ESO and MSOP Top-Up: 

Stock option agreement: 

This legal document outlines the terms and conditions of the ESO or MSOP grant, including the number of options granted, vesting schedule, strike price, and exercise procedures.

Grant notification and acceptance forms: 

These documents formally notify employees of their ESO or MSOP grant and require them to accept the terms and conditions before the options become effective.

Vesting schedule tracking documents: 

These documents track the progress of each employee’s vesting schedule, indicating how many options they have vested rights to at any given time.

Taxation of ESOs and Buyback of ESOs: 

When employees exercise their options and purchase shares, they are subject to taxes. The type of tax they pay, whether capital gains or ordinary income, depends on various factors, including how long they held the options before exercising.

Holding options for a longer period (typically over one year) can qualify employees for lower capital gains tax rates compared to ordinary income tax rates.

Company tax implications

When employees exercise their options and purchase shares, the company can deduct the difference between the strike price and the fair market value of the shares as an expense.

If a company repurchases (buys back) shares from employees, there might be specific tax implications depending on the program’s structure and purpose. Consulting with a tax advisor is crucial to understand these implications.

Conclusion: Building a Win-Win with a Strategic ESO Plan

Crafting a well-designed Employee Stock Option (ESO) plan is a powerful tool for founders. By carefully considering the key aspects outlined in this guide, you can:

Competitive ESO packages showcase your commitment to employee success, making your company a more attractive proposition compared to competitors.

When employees have a stake in the company’s ownership, their efforts become directly tied to its growth, fostering a collaborative and motivated workforce.

Utilize the appropriate pool size, allocation methods, and top-up strategies to incentivize employees without excessively diluting the ownership of existing shareholders.

Implement clear vesting schedules, strike prices, and exercise procedures to ensure responsible management of the ESO program.

Seek expert legal and financial advice to ensure your ESO plan complies with regulations and aligns with your specific company goals. By taking a comprehensive approach that addresses these crucial elements, you can create an ESO plan that fosters a culture of ownership, attracts outstanding talent, and fuels long-term growth for both your company and your employees. Remember, a well-designed ESO plan can be a win-win proposition, driving success for everyone involved.

Schedule a free demo to see how foundercrate help you with uplifting fundraising efforts of founders in raising funds. You can also sign up directly on the foundercrate platform.