The ESOP is an excellent tool, not only to motivate employees but also to retain and incentivise them to stay with the company in the long term. As an additional benefit, the employee stock option plan also allows the company to attract and incentivise talents without draining the much-needed liquidity.
After the initial overview of the different forms of employee participation and a closer look at the allocation key options, we now focus on employee participation plans (ESOP) in this blog article.
1 Employee Stock Option Plan (ESOP)
Liquidity is often tight in the start-up phase of any company. With employee shares, employees may be paid a lower (or no) fixed salary in cash, and the difference to the market salary is compensated by issuing options or shares. This is particularly interesting if someone brings in benefits that would otherwise be difficult to obtain or very expensive.
We will first look at how an ESOP is set-up (1.1) before we find out how it can help to motivate and retain talent (1.2).
In the next blog post of this series, we will dive deeper to understand why shareholder approval is needed to set up an ESOP, what it means when employees become shareholders and why it might make sense to grant options first instead of issuing shares directly.
1.1 The setup of an ESOP
With share participation plans, selected employees get a stake in the company’s share capital. Participation can be done (i) directly by transferring shares or (ii) indirectly by granting options to receive shares at a later date.
The ESOP consists of two core documents:
- Plan – here all details regarding the employee participation are unilaterally defined by the company;
- Allocation agreement – this allocates the options or shares to the participant and in return, the participant agrees to be bound by the plan (and to pay a price for the options / shares if provided for in the plan).
The core document of an ESOP is the ‘plan’, which is drawn up by the board of directors. This plan sets out all important aspects with a binding effect for the participants. Usually, the employees (participants) are not involved in this process.
Before options or shares are allocated to a participant, the respective participants have to sign an allocation agreement, in which they agree to be bound by the provisions of the plan and by which the options or shares are allocated to the respective participants.
| Competence | The board of directors is generally in charge to set up and implement the ESOP. The approval of the shareholders is needed to set-up a share pool in the form of conditional share capital (or to increase the share capital at a later date). |
| Key sections | Eligible participants Who can participate in the plan (e.g. employees, board members, and advisors). Size of the share/option pool The maximum number of shares/options to be issued (e.g. 5-20% of the current share capital). Exercise price Price participants pay to exercise the option. The strike price is typically as low as possible, to maximize the employees’ gain. Vesting schedule With a vesting schedule, options (or shares) have to be earned over time by the participants. This helps in retaining employees (see section 1.2). Forfeiture of options/return of shares Upon the occurrence of certain events, all options should be forfeited or shares returned. Typically such events are for example breach of a non-compete provision, termination of the employment contract for cause, or criminal acts against the company. General transfer restrictions Participating employees should not be able to sell the shares/options to third parties (e.g. right of first refusal for the company, blocking period). Taxation and social security Sets out who is liable for taxation and details social security payments. |
| Allocation to participants | Allocation agreement between the participating employees and the company – outlines how the options / shares will be allocated to the employees. The allocation key can be either fixed or dynamic. Fixed allocation keys typically outline the number of options / shares per function or define it ad hoc on an individual basis for key strategic participants. Dynamic allocation keys – for example based on the slicing pie methodology – sets out a method which allocates the options / shares proportionately to the employees contributions. Includes an obligation to adhere to the shareholders’ agreement. |
1.2 ESOP Vesting: Retain and motivate talent
The most important asset of a start-up is often the employees. It is therefore important to keep them motivated and retain great talent for as long as possible. An ESOP should therefore, on the one hand, attract new talents and motivate the team and on the other hand ensure that the team members are incentivesed to stay with the company for as long as possible. This is usually done by restricting the transferability of employee shares for a certain period of time and with a so-called vesting schedule (reverse vesting).
| The concept of vesting | The goal of an ESOP (and a PSOP) is to reward future performance of employees (and compensate for lower salary levels) – with a vesting schedule, employees have to ‘earn’ their shares or options by working for the company for a certain period before options can be exercised (i.e. before they are vested) or being able to benefit from shares. Market standard is a four year vesting period with a one-year cliff and quarterly vesting thereafter. |
| Example | 80 options allocated with a 4-year vesting period and one-year cliff: After one year (after the cliff period), 20 options are vested (with 60 options remaining unvested), then 5 options vest every quarter until all 80 options are vested after four years. |
If an employee leaves the company before the end of this vesting period, the unvested shares must be returned (e.g. at nominal value) or the unvested options expire. All vested shares may be retained or the options may be exercised (exchanged for shares). If you want to avoid that former employees can remain shareholders, you should include a purchase option in the shareholder agreement.
With an ESOP in place, the company will not only be owned by the founders but also by the employees. The participation aims to ensure that participating employees benefit monetarily from a potential exit, thereby making the company more attractive as an employer, retaining talent, and increasing the motivation of the employees.
2 Caveats
An effective employee participation program is nowadays virtually mandatory for all start-ups. If such a scheme is not yet in place, investors usually demand it because it helps to retain and motivate employees (the driving force behind the company’s success) in the long term.
The ESOP contains two core documents:
- Plan – here all details regarding the employee participation are unilaterally defined by the company;
- Allocation agreement – this allocates the options or shares to the participant and in return, the participant agrees to be bound by the plan (and to pay a price for the options / shares if provided for in the plan).
To retain great talent for as long as possible, any well-drafted ESOP also contains a vesting schedule. Under such a vesting schedule, participants have to earn their right to the shares over time to ensure that the team members are incentivized to stay with the company for as long as possible.
