Designing your Startup’s ESOP (Employee Share Option Plan)

What is an ESOP?

An ESOP is an allocation of options that can be granted to employees or key people in the future in the form of company shares. By exercising allocated options, they buy an ownership stake in the company at a locked in, often attractive price.

Why you should create an ESOP pool

Most early stage startups today put an ESOP in place for a range of reasons:

  • ESOP helps with talent attraction – you can offset a startup’s typical capital constraints to still attract top talent with equity options
  • ESOP helps with talent retention – vesting periods can keep key talent in place for longer
  • They help create alignment with investors, the company and the team
  • Rewards value creation by giving employees a share in that value
  • ESOP is an important part of your startup’s capital planning.

What's normal?

Seed Stage ESOP ~10%

The ESOP pool is typically topped up at each funding round.

 

Typical Unallocated ESOP Range

Seed           10-15%

Series A     7-10%

Series B+  <5%

Exit             10-20%

 

Due to dilution and unvested shares, most companies have 10-20% ESOP at exit.

Founders wear the dilution for ESOP establishment

At the first round of financing, the existing shareholders are typically just the founders. The dilution from ESOP establishment is therefore typically borne by founders. Understandably, there is sometimes reticence by founders to accept the additional dilution of establishing an ESOP. While it is really important for founders to be careful to not over dilute the company too early, it is just as important to have the capacity to attract the talent and investors needed. Most investors today, in New Zealand and abroad, are requiring companies to have ESOP in place, allocated an appropriate percentage of shares, and used as an important lever for recruiting talent

Shareholders share the dilution for ESOP top-ups

Most companies will need to raise multiple rounds of capital. It is common that a new ESOP pool is created at each round of financing. In these new rounds, top-up to the ESOP pool is typically shared between all existing shareholders, which now includes your earlier investors.

How to calculate your equity plan

For each financing period,

Recommendations:

1) Offer ESOP across the board. We believe that the best companies offer ESOP to every permanent, full-time employee or contractor (recognising that some companies opt for contracts instead, especially for certain roles). Startups cannot afford to have disengaged employees that punch a clock. Recognising the efforts and the risk that early employees took to help build your vision is, in our view, a sign of great leadership and indicative of some critical high performance startup culture.

2) Create ESOP tiers. Ideally, you want 3 or 4 clearly defined tiers of ESOP where everyone understands which tier they fall into and there isn’t a case by case negotiation for ESOP. This saves administrative time while keeping things fair and transparent. These tiers might include:

  • Executive: These are your most senior employees, generally with CXO titles.
  • Senior: These are your experienced hires, often with at least 7 years relevant experience and may have people management responsibilities.
  • Junior: These are your early career hires, individual contributors without management responsibilities.
  • Advisor: These are not employees but generally closely connected to the business for an extended period of time. Titles might include Advisory Board Member or Board Director.

Typical tier allocation ranges are:

Seed:          Executive Tier 10-15%   Senior Tier 0.25-1%    Junior Tier 0.05-1%    Advisor Tier 0.1-2%

Series A:     Executive Tier 7-10%     Senior Tier 0.1-0.5%   Junior Tier .10%          Advisor Tier 0.05-1%

 

Some talent attraction may require an SOP ‘signing bonus’ or ongoing incentive. For example, if your executive tier is 2%, you may not be able to attract that experienced COO that is critical to growing your business for less than 5%. If you’re otherwise willing to make an allocation of that size, it is worth providing yourself the flexibility to make these kinds of one-off incentive or signing bonuses.

3) Build a realistic, bottom-up equity plan to determine your actual SOP needs.
Review your capital strategy and your hiring plan between now and the next capital raise. Categorise these hires into your tiers.

4) Include a buffer.
Your hiring plan may change. You may need to provide a bigger signing bonus than anticipated. You may need an advisor to cover off strategy change. There are lots of reasons why you should include a buffer in your SOP pool. The buffer does not need to be large but should allow you some wiggle room. 1-2% is usually sufficient.

Another reason to include a buffer is to enable top-ups for existing employees. These new long-dated vesting periods can help with retention while providing performance incentive.

Closing Thoughts on ESOP

There are some excellent ESOP establishment guidelines for the mechanics of establishing your ESOP.

ESOP comes with tax implications for those receiving allocations. We recommend the company and the recipient seek legal and accounting advice. All of the recommendations, examples and templates provided should be adapted to your specific needs – seek expert advice.

This post was inspired by a great post from Icebreaker.VC, DIY Employee Stock Option Plan.

90% of angel-based NZ startups according to an NZVIF and Angel Association survey