Startups: How to design and implement an effective employee stock ownership plan
Embarking on a successful startup journey comes very much down to on-boarding the rightly skilled and motivated employees at the right time.
Given an ever-increasing war for talent, particularly fueled by the GAFAs which all grew out of the startup-phase, provides challenging times to founders aiming for attracting and retaining key talent for their startup.
However, startup founders do have a very precious asset they can bring in to succeed in such a challenge: It’s called startup equity!
As a startup founder you have the privilege to assign this startup equity through so-called employee stock ownership plans(ESOP) to your employees. Ultimately, an ESOP is a structured employee incentive scheme which provides selected employees and advisors with a way to participate in the startup’s upside potential in exchange for working or advising at a reduced rate or for free. Eventually, this enables the founders to attract, retain, motivate the ESOP participants as well as to align their interests with these beneficiaries.
Stock options as not the only one but prevailing form of ESOPs
Although there are various ESOP forms such as direct stock grants and phantom stock grants (financial reward linked to value appreciation of stock / company value), the grant of so-called pre-emption rights to shares in the start-up (“stock options”) has been established as the common standard among startups when it comes to the implementation of equity participation plans. Although stock option-based ESOPs come across with some additional administrative complexity for the employer, i.e. the startup, it ultimately has a lot of advantages, particularly from a tax point of view, for both the participant and the employer.
What important rules should be reflected in an ESOP?
Once you have taken your decision to implement an ESOP (congratulation to that! :)), it’s about setting up its very rules. This includes a variety of aspects (see below) and in particular demands for a forward-looking approach. What you want to avoid in any case is to end up with unregulated events which leave people dissatisfied or even angry.
What does Mr. Taxman say?
Taxation aspects (incl. social security charges) are an important aspect to consider for the design of ESOPs.
The advantages of running stock option-based ESOPs sit in the deferral of the taxation to the exercise date of the stock options by the entitled participant, i.e. employee or advisor. Such deferral of taxation is commonly available in European countries. This avoids the allocation of so-called dry-income which which results in a tax bill at for example allocation time when there is no cash flow to the beneficiary. With stock options, such ESOP participant can deliberatly manage its tax bill (to the extent the option terms allows for it).
ESOP participants and sizing
The question who to entitle to an ESOP is of course of a very material nature. It’s ultimately again more art than science.
According to industry titans like Index Ventures and Balderton Capital, an equity grant through stock options of at least 10% to ESOP participants at seed stage is very common. This share of equity grants subsequently increases with additional fundraising rounds to a size > 20%.
But now how to allocate an equity entitlement to a particular employee? Let’s have a look at a simplified example for a hiring following the completion of a seed funding round:
- Employee’s market salary: CHF 100,000
- Employee’s cash salary component: CHF 80,000
- Employee’s equity salary component: CHF 20,000
- Startup valuation (seed round): CHF 3,000,000
- Vesting period: 4 years
- Employee’s overall equity entitlement: CHF 80,000
- Indicative employee equity entitlement: 2,67%
If you want to involve non-cash contributing founders in your core team, Paul Graham’s well recognised formula might be likely a good starting point.
You should give up n% of your company if what you trade it for improves your average outcome enough that the (100 — n)% you have left is worth more than the whole company was before.
In such a scenario, the dilutive effect of an ESOP obviously goes beyond the above-referred one and would have to be assessed on a case-by-case-basis.
How to implement?
If you have taken the great decision to offer an ESOP to your employees and advisors, you are ready to sail down the ESOP implementation path. It is important to on-board all necessary perspectives to make your ESOP a great sustainable success. This includes having a clear view on your hiring strategy, commercials, fundraising strategy as well as having a strong legal and tax counsel on your side who understands your needs in-depth!
Last but not least, it is fundamentally instrumental to make sure that your employees and advisors understand the ESOP offer in all its variations. Make sure that they receive proper documentation in writing as well as training on the ESOP. They should have full clarity on what’s in for them, what triggers tax consequences and what happens if certain events, voluntarily or involuntarily, happen.
If you are as excited about ESOPs as I am, I am more than happy to connect with you and your team for an initial exchange!
Also check out our recent masterclass slide deck!
Let’s make employee stock ownership the new normal in the startup ecosystem in order to drive innovation to the mutual benefit of our society!!
Resources for your inspiration
- Ekwity (Paris)’s very helpful ESOP libary
- Balderton Capital’s guide to employee equity
- Index Ventures’ handbook
- Skillshare’s policy on ESOPs
- The Family (London) panel on employee equity (video)
- OptionPlan (ESOP calculator by Index Ventures)
Disclaimer: Any of the above-referred information does not constitute any sort of tax or legal advice. You should always consult your counsel if you intend to design or implement such an ESOP for your purposes.
