February 3, 2017
ESOP enables a coherent incentive model where your company’s employees are put in the same boat with founders and investors. At best, it will guide your employees daily towards maximizing the shareholder value. Secondly, a good ESOP attracts, motivates and keeps the best talent in your company. If your ESOP is not designed to support these goals, you are wasting your shares and diluting shareholder value.
Firstly, some background info:
We think that the best companies provide options to every employee who has a permanent contract. Yes, even the most junior employees should have some. This creates a healthy, forward looking company culture where everybody is on the same boat.
As mentioned above, your startup will probably have many funding rounds and a new ESOP is usually created during each round. Below is an indicative scenario where you should aim for:
Note that each new ESOP created as well as new financing will dilute the previous ESOPs and some of the options will never be vested due to the leavers. Therefore, the employees’ total ownership at exit may vary a lot (e.g. 10-20%) when comparing exited companies.
Now that you know how much stock you should allocate to your total ESOP, the next step is to decide how much you should allocate to an individual employee. One way to do this is to divide your current (and future) team members into 3-4 seniority levels like this:
Level 3 “The Vice President Level”
Your most senior team members. Usually their title is something like the VP of Sales or VP of Engineering.
Level 2 “The Senior X level”
Your second most senior team members. Usually their title is something like Senior Software Developer.
Level 1 “The Junior X level”
Their title could be (Junior) Software Developer, and so on.
The employees on the same level should get the same amount of options, otherwise you will get to enjoy a hot cup of HR problems. See the following indicative structure for the funding rounds:
*You also might come across a ‘Messiah’ that you want into your team. For these truly unique individuals you should prepare to give 5-6% in the Seed stage and 3-4% in the Series A stage.
Finally you should make a recruitment plan that would answer the following question: “How does my organization chart look like before my next round?”. So, for instance, if you have just raised your first seed round and you only have 2-3 founders in your team, your plan might be to recruit 5-10 employees before you raise your next round. Categorize those 5-10 employees into 3-4 seniority levels and voilà: your ESOP is almost ready.
It is a good idea to plan to refresh your existing team members option grants when new rounds happen or enough time passes. This keeps them incentivised by layering the vesting periods. It is best practice to set aside a small part of the new round ESOP for existing employees. You can give the refresher grants based on performance of the team members.
As mentioned above, your ESOP should attract, motivate and keep the best talent in your company. Therefore, the terms in general should be rather friendly – otherwise the ESOP will not succeed in its goal. Luckily, the ESOP contract has only a limited number of crucial terms in this respect and these will be discussed next.
Vesting period and cliff
Vesting period is a defined timeline (e.g. 4 years) when your team member earns her stock options by working (and staying) in your company.
If you don’t have a clearly defined vesting period in your ESOP, you might end up in a situation where you give 5% of your total stock to an employee at the seed stage and she leaves the company the next day while keeping her 5%. Hence, you want to have a vesting period always, no exceptions. The real question is: how long the period should be? The market practice is that in the Seed and A Stage the vesting period is 4 years (mainly because the biggest value is usually created during those 4 years). Go with 4 years, no shorter or longer. In later stages the period can be 3 years.
Besides the length of the vesting period, you should also define the frequency when your employee vests her stock options. The most common models are monthly or yearly-based vesting. If you have the best practice 4 year or 48 month vesting period and you have given 5% to your employee in Jan 1, 2017 her vesting schedule looks like this:
As you can see from the example above, the monthly-based vesting is a lot more stable whereas the yearly-based vesting creates a vesting peak once a year. Benefits of the yearly-based vesting (from a company perspective) is that if your team member leaves, for instance, in Aug 1, 2017 she will lose all her stock options whereas in the monthly-based vesting she will leave the company with her vested stock options of 0.729% (=5% / 48 x 7). On the other hand, the yearly-based vesting peak is not optimal either. You don’t want to be in a situation where many of your employees simultaneously gives you the letter of resignation after the new years party. Therefore, when choosing between these two models, one should prefer to go with the monthly-based vesting. For practical reasons, you may still want to restrict the share subscription periods to certain months, e.g. June and December, each year so that you don’t need to file new shares for registration each month (and pay the handling fees each month).
A market standard is to have a one year cliff in the vesting. That means that if your team member leaves your company during the first 12 months, she does not get to keep any stock options. Recruitment is a difficult job and you want to have some insurance that your new team member is committed to stay for at least 12 months.
Good leaver and Bad leaver
The best practice is that the good leaver and bad leaver situations are aligned with the founders’ SHA. And when aligned right, their definitions should be summarized as follows:
In order to keep your ESOP fair and motivating, we recommend the following:
Acceleration (single-trigger, double-trigger)
Acceleration means what happens to the unvested options when the company is acquired at exit. A single-trigger acceleration means the unvested options immediately vest. Double-trigger means they continue vesting, but vest immediately if the employee is terminated.
We recommend double-trigger vesting for most employees as this maximizes the company’s equity value in an exit, because the acquirer knows the continued vesting already incentivises the staff and they have a lesser need for other types of retention incentives.
Adherence to the SHA
To ensure e.g. a smooth exit, it should always be a precondition for the subscription of shares with
the stock options that the option holder adheres in writing to the shareholders’ agreement.
Needless to say, this part is only for the Finnish companies and the people living in Finland. It is always best practice not to rely on Google when it comes to such topics as taxation but instead turn to an expert in the matter.
Generally, the option holder is taxed on the spread, i.e. the difference between the fair market value of the shares and the exercise price, when options are exercised, and the taxable benefit arising from the options is determined at the time of exercise. The spread at exercise is treated as additional salary and is included in the option holder’s overall income at the progressive income tax rate. Additionally, the company needs to withhold income tax and remit applicable social security contributions related to the spread.
For the Finnish companies: don’t forget that you must file the documents of your ESOP, including the subsequent share subscriptions, to the Patent and Registration Office (i.e. “PRH” in Finnish).
The ‘optimal’ ESOP described above is just one model and is described only as an example, not as advice to be followed literally. You might need to come up with a different model due to various reasons and situations. And because various situations require various models, we recommend you to ask for an advice from someone who knows what she is doing.