Founder’s guide for building ESOPs for their venture
After starting up, the key thing for all founders is to get an A team together. In the initial days, with limited cash available, how do founders attract good folks to join them? Uncertain future, long working hours, no statutory benefits (PF, Insurance etc.) — the list of risks is long. Apart from the vision & mission that make a big difference in attracting top talent, what would make someone work for a start-up? It is the ownership in the company which excites many and incentivizes them to align their efforts to the company’s success. It also gives them a potential non-linear positive outcome for their sacrifices early on, should the startup do well.
“I hold the key to my own as well as company’s growth”, said one of the early team members in a healthcare startup — illustrating ESOP as an important tool for start-ups in building teams.
This blog attempts to demystify ESOPs and give a simple structure to help founders make a good ESOP policy for their venture. The blog has three sections:
1. Understanding ESOPs
2. Designing ESOPs
3. Implementing ESOPs
- Understanding ESOP
ESOPs are options given to an employee that convert into shares at some point. Here are the major stages one needs to know to get started with ESOPs.
Grant: Right offered to an employee to buy a certain number of shares in the company’s stock for a set price (Strike Price / Grant Price / Exercise Price)
Vest: Vesting is a time bound (or milestone bound) schedule to earn the rights to exercise a certain number of shares
Exercise: Exercise is the process of buying the vested shares from the company
Sale: Selling the exercised options
So, an employee can sell what has been exercised, can exercise what has been vested and vest what has been granted.
Let’s understand this in more detail with the help of the table below. Certain assumptions that have been made are: ESOP allocation in the CAP table (100K shares) has not changed in subsequent rounds and Employee X’s allocation to ESOP has remained at 10k shares.
“X” has been given 10k shares which corresponds to 1% of the company. The value of his holding and the dilution %age with each round of funding is reflected through the table above. As the company raises subsequent round of financing, although there is a dilution in the ESOP % for X, the value keeps on increasing. This is further reflected in the diagram below. Hence, while introducing ESOP to the employees or offering a grant letter, it is important to communicate the impact of value that ESOP will bring to the Option grantee.
Taxation
Though ESOP is an attractive tool to compensate/ reward the performers, employees need to be made aware of its tax implication. In an ESOP scheme the tax impact is in 2 stages, once at the time of exercise and the next at the time of sale of shares.
At the time of exercising the shares, the employee has to pay the Strike price. The difference between the prevailing Fair Market Value and the strike price would become the notional gain to the employee and will get added to the compensation. The employee will be subject to tax as per the income tax slab rates and it is the duty of the employer to deduct TDS on behalf of the employee. The treatment depends upon the domicile country. So, it is better to check with the experts while determine exact tax liability.
At the time of sale, the employee will be subject to capital gains tax. Sale can be either through an M&A, company buy back, IPO or secondary sale. The duration of holding will determine the nature of capital gains (LTCG/STCG). Please note that the holding period will start once the shares are exercised.
The impact of taxation is further explained with the following diagram:
Certain points to understand about ESOP
- It is a form of remuneration
- It is an Option and not an obligation
- Exercised shares rank pari passu with other shares in same class
- Exercised shares are entitled to dividend & voting rights
- ESOP is not transferable other than on death
- Promoter or Director holding more than 10% of equity shares is not entitled to ESOP scheme [this may be different in different countries]
2. Designing of ESOP
Designing Grants
The two key decisions to be made in this stage are the number of options and the strike price.
Number of Options
This is often very confusing. As a founder, you struggle to figure out how many options to grant to whom. Here we present a back of the envelop method (using FMV) to bring some method to an otherwise arbitrary process.
Say Employee X’s market salary is $70k per annum and the startup founder can pay cash compensation of only $60k per annum. Every start up has a cash crunch in the initial phase. So, to continue with the example, X is paid $10k less each year. Assuming ESOP to vest over the next 4 years, the total compensation payable as ESOP is $40k ($10k x 4). Considering the current FMV per share is $4, the shares that can be allocated to X will be 10,000 shares ($40k/ $4). For simplicity, it is assumed that the amount remains same over 4 years (10K USD).
Please note that this is just a ball park number. One can increase / decrease the number according to how well you want to reward the person.
In an early stage start-up, say from Seed to Series A, where there is a cash crunch, the guiding factor for the number can be compensation. As the company progresses further and raises subsequent rounds, one can look at the reward angle more than compensation as by now hopefully the employees are on market salaries.
Grant/ Strike/ Exercise Price
The Grant/ Strike / Exercise price is the set price at which the right is offered to an employee to buy a certain number of shares.
There are no rules around determining the Grant price. One can choose according to their preference. Recommendation is to keep it as low as possible for as long as possible.
So to start with, till Series A round, one could keep it the same as par value. Post that, one can increment by some factor. In the example we have taken, we are incrementing it by half of the ratio of share prices of the relevant rounds.
Below diagram will explain how the strike price moves as the company raises subsequent rounds of investment and the stages where ESOP can be used as a compensation tool and reward tool.
Vesting
Vesting is another important criterion while designing the ESOP scheme. When an employee leaves the company, they take along with them the knowledge and the experience. Hence vesting assures a long term retention plan. 4 year vesting with 1 year cliff is a typical vesting curve for any start-up. Vesting post the one-year cliff can be monthly, quarterly, half yearly or yearly. The first year cliff usually takes care of the mis-hires and mis-fits which happen in any startup. Normally, they churn out within the first year and therefore the ESOPs allocated to them come back to the pool to be allocated to others.
A typical example of time based vesting curve is depicted by the diagram below:
Generally, 4 year curve with one year cliff and quarterly vesting is a fair option.
There are a few variations that could also happen, although both are not popular. One is called Back loaded vesting. For a Back loaded vesting — where vesting is more in the later years than equal vesting across 4 years.
Another form is performance based vesting, where shares are vested on meeting certain milestones. However, both back-loaded vesting and performance vesting is not very popular in the practical world.
Apart from the vesting schedule, we also need to determine what happens in different scenarios when employees leave. The following table covers it
Exercise
To make the policy complete, one also needs to look at the conditions around exercise when an employee leaves the company. One needs to decide the time frame in which they need to exercise the vested options. Please note that the options not exercised within that window will lapse. Since there is a significant money outflow from the employee to exercise, there are different practices followed:
1. 90 Day window
2. 5 or 10 year window extendable by board approval
3. Infinite (till sale)
3. Implementation of ESOPs
Now that we have understood and designed the ESOP, we need to announce and implement the scheme to the workforce. Below are few key steps for the implementation of the ESOP scheme.
- Work with a lawyer to get an ESOP Policy drafted
- Communicate to Employees
- Explain how ESOPs work
- Communicate the value of ESOPs
- Work out an exit price estimation
- Register your ESOP policy with the appropriate authority and give grant letters to folks
It is always advisable to a founder of an early stage start-up to award ESOP to all employees regardless of seniority or specialisation. This kindles the ownership among all and gives impetus towards company’s growth.
Communicating the Value of ESOPs
Quite often one finds that employees do not appreciate the value of the ESOPs. It is the responsibility of the founders to take a pro-active approach towards this and explain it to their team. One way is to communicate how ESOPs work and the other one is to communicate what the employees can potential make when an exit happens. While the first part can be done in all — hands, the potential upside is better done one-on-one as it will be different for each one of them.
For communicating the potential upside, one can estimate the exit value of the company and the dilution one will go through to get there and then come up with the worth of the ESOPs. Both the potential exit value and current FMV value is a good practise to communicate.
In our example above, let us say that the company gets sold at 500M USD, the share price would be $204, hence the worth of X’s ESOPs would be $204*10,000 = ~2M USD.
Hope you found the above blog useful for designing ESOPs for your venture. You can see the same information in a slide deck as well below.
In case of any questions, please reach out to info@piventures.in
Team pi
PS: Many thanks to Abhinav Singh, Partner @ Anoma Legal for his valuable inputs
