Employee Equity — Designing the right stock option plan / ESOP Senovo Playbook

Markus Grundmann
Apr 18, 2018 · 7 min read

I believe that the efficient usage of stock option programs for employees are one of the most underused and misunderstood tools in the European startup ecosystem. As a result, investors are often confronted with seemingly total random situations ranging from “no ESOP at all” on the one hand to overly generous offers of several percentage points for non C-level employees in companies which already have significant traction on the other hand.

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This is going to be a long post. It’s best to get a coffee first. 😉

Note: For simplicity I will refer to employee stock options as ESOP shares. In Germany we use a virtual share program, in the US and UK this would probably be normal options. So, depending on your jurisdiction the exact “implementation” may vary. Also, neither Senovo or I are qualified to provide legal or tax advice. This article tries to explain our thinking on this subject and before implementing any of this we strongly recommend to get advice from a legal council and tax advisor.

In general, when it comes to employee equity the goal is to balance dilution and retention & rewarding of (critical) employees.

Our colleagues at Balderton, Index Ventures and Union Square have also published super helpful posts / ebooks on the subject (links are at the bottom) which I can only recommend to read as well.

A good employee stock option plan should contain the following key terms. Most of this is considered by many VCs and entrepreurs as best practice. But to make this article the most useful, I’ll try to cover all the bases and provide a comprehensive overview:

1. Strike Price with an adjustment of strike price by liquidation preferences

2. Margin business structure

3. Call option

4. Good leaver / bad leaver

5. Cliff & Vesting, no accelerated vesting

6. No Protection from Dilution except of “internal” increase of share capital

I’ll explain each of these points next and conclude with how much to grant and how to communicate this to employees.

1. Strike Price

I prefer to set a strike price to the share price of the last investment round. This means that the employee’s shares only have a positive value (intrinsic value) if the price at which he executes his options is larger than when he joined. You might want to offer a lower strike price in special cases such as when the previous salary of the employee was much higher and you need to compensate for the lower cash offer

Most ESOP plans I have reviewed have a “flaw” in the calculation of this difference of the strike price and the “exit price”. Liquidation preferences and costs of the transaction (typically lawyer and M&A banker fees) are typically subtracted from the exit price before the “share price of the transaction” is established. This can lead to a much lower share price than the “true” share price since liquidation preferences can be substantial (especially with VCs who use participating preferred structure — which by the way I don’t like as well). To fix this, I suggest multiplying the strike price by [Exit Price — transaction costs — liq prefs] / [Exit Price — transaction costs]. This way the strike price gets adjusted proportionally to the share price.

2. Margin Business

The ESOP should be defined as a margin business which means that the employee receives a payment of [[exit share price — strike price] x number of options]. If this is not done, then the employee would have to transfer the value of [# of options x strike price] before receiving a payment of [# of options x exit share price]. If that were the case and the employee would have 1000 options with strike price EUR 100, you would expect him to drum up EUR 100k.

3. Call Option

I have not seen this one used widely but a call option can be used to ensure that long term valuable and loyal employees are rewarded with a significant value, while even larger grants to employees who leave relatively early are not that valuable and dilutive.

The call option allows the company to buy back vested options if an employee decides to leave. Provided the company has the liquidity to do so, this allows to control the “option shareholder” base and an ESOP which has been bought back can be granted again to a new employee.

Let’s make an example: an employee receives and vests options at a notional value of EUR 20k (notional value = share price x number of options; e.g. set at 10% of annual salary of EUR 50k over 4 years). During this time the company raises another financing round and the share prices doubles. The employee decides to leave the company after the financing. Now the company has a purchase option to buy back the ESOP worth EUR 40k notional value. The strike price was set at the valuation of the option grant, and thus the intrinsic value is EUR 20k (EUR 40k notional value — EUR 20k strike price). If the company opts to use the call option then it would need to pay the departing employee EUR 20k.
If, on the other hand, the employee would have remained with the company for another 2 financing rounds the share price would have continued to double, then the option package would have had an intrinsic value of EUR 140k.

4. Good leaver / bad leaver

If an employee leaves as a good leaver without any reason such as fraud or serious misconduct his vested shares are subject to the call option process. If an employee is fired for cause, sets up a competitive business or departs to a competitor, his options expire without substitution and compensation.

5. Cliff & Vesting, no accelerated vesting

Usually an employee is granted a certain number of options with a vesting period over 4 years and a 1-year cliff. This means that for the 1st year, no options vest and with the completion of the 1st year after the option grant, the employee receives the first quarter of the grant. Over the following 3 years, the 1/36th of the granted options vest on a monthly schedule to the employee.

I suggest to not allow for accelerated vesting in case of an exit since the company still needs to hit the post acquisition mile stones over the following period of usually to years and so the job is not done yet. Also, employees who just very recently joined would all the sudden be on the same level as employees who worked hard over the last 4+ years to get the company to where it is at the moment.

6. No Protection from Dilution except of “internal” increase of share capital

Sometimes I see programs where a certain percentage, e.g. 1% of the exit proceeds, are granted to employees. This means that the employee has an “anti dilution” protection. An employee should be treated in the same way as other shareholders and if additional shares are created in funding rounds then they should be affected in the same way as all the other shareholders. You can later use retention grants to compensate for the dilution of multiple funding rounds.

Having that said, there is one exception which is important to protect the value created through the ESOP package. Technically, the shareholders could decide to make an “internal” increase in share capital. This is basically a share split: for each old share a certain number of new shares are created an allocated to the holders of the old shares proportionate to their shareholding. If the ESOP share count would not receive the same treatment it would be only half as valuable in case of a 1:2 split.

This has been covered pretty well in the links referenced at the end of the post. For completeness I’ll just briefly lay out a suggested structure. Please note that the numbers mentioned are more for illustrative purposes:

A concrete example could be as follows:

· A VP finance gets EUR 100k annually

· The ESOP is calculated based on 25% of salary per anno, i.e. EUR 25k annually or EUR 100k in 4 years

· If the company is a successful (5x exit), the 4 year ESOP component is worth 500k

· If the company is very successful (10x) the annual ESOP component is worth 1m

The remaining challenge when using ESOPs I see is how to communicate this. The language and mechanics are quite complicated if you’ve never encountered terms such as cliffs, vesting, call options and notional value. I often see the mistake that the terms and conditions which I explained above are given to the employee together with an allotment letter full of legalese. While it is technically correct, it is also the responsibility of the founders and board to ensure that the employees understand and value the options they are about to receive. For this I have created an offer presentation which helps to explain the terms and mechanics in an easier to understand way. But it is important to note that this presentation is only an accompanying “tl;dr” style document and no substitute for a proper T&C and allotment letter.

Balderton
Guide to Employee Equity: https://equity.balderton.com/

Index Ventures
Rewarding Talent: https://www.indexventures.com/rewardingtalent#intro

Fred Wilson
Some Thoughts On Equity Compensation https://avc.com/2018/01/some-thoughts-on-equity-compensation

Employee Equity: Dilution https://avc.com/2010/10/employee-equity-dilution/

Employee Equity: How Much? https://avc.com/2010/11/employee-equity-how-much/

senovoVC

We're a European early stage VC Fund focused on B2B SaaS…

senovoVC

We're a European early stage VC Fund focused on B2B SaaS investments.

Markus Grundmann

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Startups, entrepreneurship and technology. Partner at B2B SaaS VC @senovovc

senovoVC

We're a European early stage VC Fund focused on B2B SaaS investments.