Over the past few weeks, I’ve been talking to several founders about employee stock ownership plans (ESOPs).
A key ingredient of many high-growth startups, ESOPs are used to align key team members to the company’s long-term success by providing them with exposure to the growth of the startup’s stock value.
Once a startup reaches significant scale or is sold, eligible employees can unlock the value of their ESOP stake by selling some or all of their stock or options.
ESOPs can provide long-term alignment between the startup and employees, as they are often part of an employee’s compensation package.
Most ESOPs are also subject to vesting, which promotes job retention and employee hiring. In addition, when employees sell their shares or options, it can have 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 important things to consider when implementing an ESOP.
While some ESOPs will issue stock and other options, the number of securities that will be issued to an individual employee will depend on the current (and future) value of the startup, the employee’s seniority, and the relationship between the ESOP and the remaining compensation package. of the employee.
Vesting is the process by which an employee “earns” his stock or options. It is common for the waiting period to be three or four years, often with a one-year cliff. The cliff means that the employee must be with the startup for at least a year before they are entitled to any of their securities.
If employees were allocated 1,000 units over a four-year vesting period and they left after two years, they would be entitled to 500 units or half of their allocation.
Many ESOPs take into account accelerated vesting in the event of a trade sale or merger. This means that an active employee who may have only been with the company for two years will still receive 100% of their entitlement if a trade sale occurs then.
ESOPs often have good/bad severance packages to protect the company when an employee leaves. If an employee is a ‘good’ dropout, he will keep all of his acquired shares/options. If an employee is a ‘bad’ outgoing employee, he may lose some or all of his vested shares/options.
Reasons for being a ‘bad’ leaver could be, for example, violating their employment contract or committing fraud or a criminal offence.
It is important to recognize that the shares/options allocated to an ESOP as a percentage of the total number of shares in the startup may decline over time.
If more new shares are issued to new investors and the ESOP pool is not replenished, the ESOP will make up a smaller percentage of the company’s total value.
It is common for investors, such as VCs, to ask for a certain percentage of the stock in the company that is set aside for an ESOP at the time of their investment.
For example, an investor’s term sheet may state that an ESOP must hold 10% of the stock, on a fully diluted basis, after their $5 million investment. Assuming there are no other investors in the round and a post-money valuation of $25 million, this means that the investor will own 20% of the shares in the company, with the ESOP containing $2.5 million in shares and the existing shareholders (and founders!) who own $17.5 m.
It could be argued that the company has received a pre-money valuation of $20 million, as $2.5 million in stock has now been allocated to ESOP and existing shareholders will now own 70% of the stock.
While this may seem unfair, there is good reason for the investor to request the creation or expansion of an ESOP.
A greater ESOP, combined with the funds raised, will enable the startup to attract and retain high-quality employees, which will help the company’s growth, and as the startup grows, it will need to hire even more!
Therefore, it is common for ESOPs to expand with each subsequent funding round.
In 2015, the Australian government made changes to the tax regime of ESOPs.
Previously, employees who received stock or options had to pay income tax the moment they received these securities, even if they had not sold them.
Under the new changes, employees to whom stock or options are issued under a compliant ESOP will not be required to pay taxes on their issued securities until they receive a financial benefit from those securities.
There are several tests that a company must meet in order to be eligible for the new scheme. Professional legal and accounting advice is a must.
- Benjamin Chong is a partner at venture capital firm Right click on capital letterinvestors in bold and visionary tech founders.