Over the last few weeks, I’ve been having conversations with several founders about employee share ownership plans (ESOPs).
An important ingredient of many fast-growing startups, ESOPs are used to align key team members to the long-term success of the business by providing them with exposure to the growth in equity value of the startup.
Once a startup achieves significant scale or is sold, eligible employees can unlock the value of their ESOP interest by selling some or all their shares or options.
ESOPs can generate long-term alignment between the startup and employees as they often form part of an employee’s remuneration package.
Most ESOPs are also subject to vesting, which encourages job retention and employee tenure. Further, when employees sell their shares or options, there can be a positive impact on the community.
Many angel investors have been able to build a portfolio of next generation startups thanks to being ESOP beneficiaries of successful companies.
Here are some key issues to consider when implementing an ESOP.
Allocation of shares or options
While some ESOPs involve will issue shares and others will issue options, the number of securities to be issued to an individual employee will depend on the current (and prospective) value of the startup, the seniority of the employee and the relationship between the ESOP and the employee’s remaining remuneration package.
Vesting is the process through which an employee ‘earns’ their shares or options. It is common for the vesting period to be three or four years, often with a one-year cliff. The cliff means the employee needs to be with the startup for at least one year before they’re entitled to any of their securities.
If employee were to be allocated 1,000 units over a four-year vesting period and they left after two years, they’d be entitled to 500 units or half of their allocation.
Many ESOPs make allowances for accelerated vesting in the event of a trade sale or merger. This means an active employee who may have only been with the company for two years would still receive 100% of their entitlement should a trade sale occur then.
ESOPs often have good/bad leaver provisions to protect the company when an employee leaves. If an employee is a ‘good’ leaver, they continue to keep all their vested shares/options. If an employee is a ‘bad’ leaver, they may forfeit some or all their vested shares/options.
Reasons for being a ‘bad’ leaver may include breaching their employment agreement or committing fraud or a criminal offence.
It’s important to recognise that the shares/options allocated to an ESOP as a percentage of the total number of shares in the startup can decrease over time.
If more new shares are issued to new investors and the ESOP pool is not topped up, the ESOP will account for a smaller percentage of the total value of the company.
It is common for investors, such as VCs, to request a certain percentage of shares in the company is reserved for an ESOP at the time of their investment.
For instance, an investor’s term sheet may state that an ESOP is to contain 10% of shares, on a fully diluted basis, following their investment of $5 million. Assuming no other investors in the round and a post-money valuation of $25m, this means the investor will own 20% of shares in the company with the ESOP containing $2.5m worth of shares and the existing shareholders (and founders!) owning $17.5m.
It could be argued the company was given a $20m pre-money valuation, because $2.5m worth of shares is now allocated to ESOP and the existing shareholders will now own 70% of shares.
While this may seem unfair, there is a sound reason for the investor to request for the establishment or enlargement of an ESOP.
A larger ESOP, in combination with the funds raised, will allow for the startup to attract and retain high-quality employees, who will help the growth of the company, and as the startup expands, it’ll need to hire even more!
That’s why it’s common for ESOPs to get enlarged with each subsequent round of financing.
In 2015, the Australian government introduced changes to the taxing regime of ESOPs.
Previously, employees who were issued shares or options were required to pay income tax at the time they received these securities, even if they hadn’t sold them.
Under the new changes, employees who are issued shares or options under a complying ESOP will not be required to pay tax on their issued securities until they receive a financial benefit from these securities.
There are several tests a company must meet to qualify under the new scheme. Professional legal and accounting advice is a must.
- Benjamin Chong is a partner at venture capital firm Right Click Capital, investors in bold and visionary tech founders.