In the competitive world of startups, it is essential to attract and retain top talent. They are the driving force behind a company's success, and it is crucial to keep them motivated and invested in the enterprise's growth. One way to achieve this is through an Employee Share Option Plan (ESOP) (also often referred to a share incentive plan (SIP)).
In this introductory guide, we will explore the intricacies of ESOPs. We'll dive into what an ESOP is, discuss the benefits and disadvantages, highlight key considerations, and shed light on the legal issues associated with ESOPs. Let's get started!
What is an ESOP?
An Employee Stock Ownership Plan enables employees, including consultants and directors, to acquire ownership in a company by purchasing shares or options at a discounted price. By exercising their options, employees become partial owners, potentially profiting when the company's shares increase in value above the exercise price. Implementing an ESOP can help incentivise employees and ensure that they are invested in their company's success while reaping potential financial benefits.
Benefits of ESOPs
ESOPs offer a range of benefits for both startups and employees, which include:
Attracting top talent. Start-ups often face resource constraints, but ESOPS offer an excellent opportunity to attract and retain talented individuals during the early stages. By joining and contributing to a start-up's growth, employees can also share in its success. This makes ESOPs a valuable tool for start-ups looking to recruit top talent.
Incentivising and retaining employees. ESOPs are a common component of employee remuneration packages. By granting employees ownership in the company through shares, ESOPs help maintain employee focus on company performance and market value. This fosters a sense of ownership and motivation, leading to greater employee commitment and retention while fuelling company growth.
Reducing cash outflow. Since ESOPs can be used as an alternative to cash bonuses, they help startups conserve cash with no/minimal up-front costs incurred while also incentivising and rewarding employees.
Alignment of interests. ESOPs offer a valuable alternative to cash bonuses for startups. They help conserve cash by avoiding or minimizing upfront costs, while also incentivizing and rewarding employees. This not only supports financial stability but also improves motivation and morale. Incorporating ESOPs into a company's compensation strategy can be a smart move for long-term growth and success.
Disadvantages of ESOPs
While ESOPs have several advantages, they also have some disadvantages, which include:
1. Dilution of shareholding. When founders issue ESOP shares, it can lead to dilution of other shareholders. This is why professional investors often request the creation of an ESOP pool before investing, ensuring that the issuance of ESOP shares doesn't dilute their ownership. Taking this step not only protects professional investors but also maintains the interest of other shareholders.
2. Valuation issues. ESOPs are commonly implemented during the early stages of a start-up to attract talented individuals. However, accurately valuing shares or options can be a challenge due to the lack of revenue.
3. Administrative complexity. Setting up and managing ESOPs can be quite time-consuming and require a significant amount of administrative work. This is especially true when dealing with ESOP shares that are subject to a cliff and/or vesting period.
Key considerations when setting up an ESOP
Before implementing an ESOP, startup founders should consider the following key factors:
A. What percentage of the company will be reserved for the ESOP?
It is crucial for founders to determine the valuation of the company and accordingly decide the number of shares that are to be subject to an ESOP pool.
B. What class of shares will be reserved for the ESOP? Will ESOP participants have voting rights?
Companies often have the option to create different classes of shares, giving founders the choice to establish a separate class specifically for ESOPs. If the ESOP shares are intended to be ordinary shares without voting rights, a distinct class of ordinary, non-voting shares will need to be formed. This might necessitate amending the company's articles of association to properly reflect these different share classes.
C. Will ESOP participants actually own shares or only contractual economic rights?
In a classic ESOP, participants can purchase real shares in the company. However, there may be situations where founders are unable to grant ownership of actual shares to ESOP participants, such as when a separate non-voting class of shares cannot be issued for the ESOP pool. In such cases, founders need to decide between implementing a classic ESOP or a phantom ESOP. A phantom ESOP is essentially a contractual right that mimics the economic benefits of share ownership.
D. What will be the vesting period for the options?
ESOP shares typically have a cliff period and a vesting schedule. Here's what that means: as an ESOP participant, you can acquire company shares by exercising your options, but it depends on how long you stay with the company.
During the cliff period, you can't exercise your options until after a certain period. With a vesting schedule, the number of shares you can exercise each month or quarter depends on how many shares vest.
By way of example, if an ESOP participant is to be allocated 1,000 shares subject to a: (a) one-year cliff period; and (b) 4-years vesting period with a monthly vesting frequency, then:
(i) During the one-year cliff period, the participant is not entitled to any options/shares;
(ii) At the expiry of the one-year cliff period, the participant will be entitled to exercise his/her option over 250 shares; and
(iii) Subsequent to that, the participant will be entitled to exercise his/her option over 21 shares each month until the expiry of the remaining 3-years’ vesting period (post-cliff period) and till the participant is allocated the option over such 1,000 shares.
E. What will be the exercise price of the options?
Founders should consider the exercise price applicable to the ESOP shares. The exercise price is the price at which an ESOP participant can buy the shares. It is set at a discounted price per share, lower than the fair market value of those shares.
F. How will the ESOP be administered and monitored?
ESOPs are typically managed and overseen by the board. In cases where participants are subject to cliff and/or vesting periods, it is advisable for the company to establish a clear table for each participant. This table should outline the total allocation of ESOP shares/options, the duration of the cliff period, as well as the number of vested and unvested shares.
G. What will be the strike price for the company to buy-back ESOP shares?
When an ESOP participant resigns or is terminated from their role in the company, ESOPs typically offer the company the opportunity to repurchase the ESOP shares held by that participant. The strike price at which the company may repurchase the ESOP shares from the participant needs to be considered in the ESOP, depending on whether the participant is classified as a good leaver or a bad leaver.
Legal Issues to Consider
Once the commercial terms of the ESOP are clarified and agreed, it is highly recommended for companies to engage an experienced law firm with expertise in dealing with start-ups. This is crucial in order to prepare the ESOP and its ancillary documents such as the grant agreement, board resolution, FAQs for employees, and more.
Moreover, depending on the company's location, seeking legal advice on the compliance of ESOP terms with applicable securities laws as well as understanding the tax implications for both the company and employees resulting from the implementation of the ESOP and the exercise of the options stipulated therein is of utmost importance.
Although it is not yet common, companies are increasingly tokenising ESOPs, where participants receive an NFT or another token instead of eligible shares in the company. In such cases, it is highly recommended for the company to seek legal advice to ensure compliance with local laws regarding the creation, issuance, and allotment of NFTs and/or other tokens.
Conclusion
ESOPs are a powerful tool for startups aiming to attract, retain, and motivate top talent. To ensure a successful implementation, founders must carefully analyse the key commercial aspects related to ESOPs. Furthermore, it is crucial for startups to engage experienced legal and financial advisors who specialize in the startup landscape. This will help guarantee appropriate compliance with local laws regarding legal, tax, and financial matters.
Published by: Jamie Tredgold and Shiladitya Majumdar at Support Legal.
This material is provided for general information only. It does not constitute legal or other professional advice.