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The ESOP Playbook

July 9, 2024

As an early-stage founder, you understand the importance of attracting and retaining top talent. You also know that this should happen while conserving cash and aligning employee interests with the success of your startup. Not an easy task, right? Yet, this is precisely where the strategic implementation of an Employee Stock Ownership Plan (ESOP) can play a transformative role.

An ESOP is essentially an employee benefit plan that offers workers a stake in the company through shares. It is a powerful tool that not only rewards but also fosters a culture of ownership, improves corporate governance, and aligns the interests of employees with those of the company’s owners and managers.

There are many ways to approach creating an ESOP, as well as different things to consider and traps to avoid. To help you navigate through it, we tapped into the expertise of Stoil Vasilev, Venture Partner at Eleven Ventures, and Vice President of Corporate Development at SumUp. He has been responsible for creating and managing SumUp’s ESOP for the past 8 years.

The A, B, and C of equity compensation


Equity compensation is based on the principle of risk-reward. Employees who join a small company at an early stage, often leaving behind secure jobs, face significant risk. The potential reward comes in the form of equity ownership, which can yield substantial returns if the company succeeds.

Equity is one of the most important incentive mechanisms that a startup has at its disposal. However, it is the most expensive type of compensation and shouldn’t be given away lightly. One extreme of distributing the company equity is that every company employee is entitled to stock options. The other is that only the founder(s) hold it and there’s no ESOP. So what is the way to go? 

Allocate a portion of the equity pool for ESOP, considering various stakeholders such as founders, investors, and employees. Typically, startups allocate around 10-15% of equity to ESOP, while more developed companies with hired boards and management may allocate 20-25%. The standard approach is that the ESOP is awarded to a limited group of people, who are most important for the development of the business. The more widely the equity is rewarded, the lower the perceived value for the beneficiaries could be.

The ESOP is designed to (1) give a long-term incentive plan (ultimately paying cash to the option holders) that is competitive with what is offered in the market (retaining people in the company for a longer period), and (2) fit within the financial budget because it is not a cash compensation.
Stoil Vasilev
Venture Partner at Eleven Ventures, VP of Corporate Development at SumUp

Types of equity programs

✔️ Cash-settled tracking instruments

Consider implementing cash-settled tracking instruments that follow the performance of the company’s equity. For example, if the company is worth $10M today, and is sold for $20M, employees will receive the equivalent of X number of shares in the company in the form of a cash bonus upon exit, but they will not have actual shares. Such instruments allow employees to receive the equivalent value of shares without granting them actual ownership. This approach can help address legal uncertainties and provide employees with financial incentives.

“Based on my experience, ESOP should always be settled in cash and in only very rare cases have the program settled in real shares. If issuers allow for employees to exercise, they may end up with too many shareholders, which may have some legal and tax implications.”

✔️ Direct share issuance vs. Equity management vehicle

You can choose between directly giving shares from the company’s cap table to employees or establishing an equity management vehicle. The latter option involves giving shares to a separate entity controlled by the board members or founders, which can issue call options or provide trust shares.

This vehicle is 100% owned by the company, and its sole function is to give stock options in any form. However, it needs to be confirmed that this is possible under the legislation of the respective country where the holding company is located. Not all countries allow the company or its subsidiaries to hold treasury stock of the company itself. Most jurisdictions require the liquidation of the treasury stock after a certain period of time.

Structuring an effective ESOP: Guiding principles to consider


1️⃣ Starting ESOPs midway: ESOPs can be implemented at any stage, even if not initially structured – it is not necessary to make the program retroactive. When implementing an ESOP, however, you must determine the strike price (the price at which employees can exercise their options). A company can create a rolling indicator, for example 3x last 12 months revenue, or 5x EBITDA, or something else, that can be updated every month on a rolling basis.

“Value in companies is created over time. If a new employee comes and gets the same price as an old employee, this means that all the value created in the company is shared with the new guy, even though he did not contribute to the creation of this value. There must be a simple rule for the company to determine consistently its approximate value for the award of the options and this should be incorporated in the rules.”

2️⃣ Vesting: Vesting in an ESOP refers to the process of employees gaining ownership of stock options or shares over time, after a “cliff” period has passed. The “cliff” is a time period that has to pass before an employee’s benefit plan can vest. The vesting period is typically four years and after the first year, it can occur quarterly, monthly, etc. The common one-year cliff provision requires an employee stay with a company for at least one year before any equity or stock options begin to vest. Leaving before this point means forfeiture of all unvested equity/stock.

After the one-year cliff, vesting might continue on a schedule. For example, with 25% of shares available after the first year and the remaining amount spread out monthly over three years. This arrangement benefits both companies by retaining skilled workers and aligning their interests to long-term success, while also providing employees with a clear timeline and incentive for their commitment to the company.

3️⃣ Managing liquidity events and secondary rounds:

Consider creating liquidity events, such as buybacks or secondary rounds, to address the needs of long-term employees seeking liquidity. These events can provide opportunities for employees to sell their vested shares, aligning their interests with the company’s growth. For example, if you are already in Series B and want to raise 10 million euros, you can decide to offer investors 2 million euros out of the whole round from the employee stock option plan.

“Some companies do buyback of options from employees leaving the companies or employees who are working for many years and need to feel some liquidity. My advice is to always have this at the discretion of the company and never promise to make it available to everyone.”

4️⃣ Overseeing of the ESOP: The management of ESOPs can be assigned to various roles within the company, such as the investment relations team in a scaleup or the CFO at a startup. The key is to have individuals familiar with the shareholders’ agreement and capable of overseeing the program effectively.

“Every company should have a decision-making body or a committee for equity awards. It is a good practice to have investors in the company participating in the committee as this is putting pressure on the management to be able to justify all the awards it gives away.”

Aligning interests: employer, employee, and investor


Equity compensation aligns the interests of employees and investors by incentivizing employees to contribute to the company’s growth and success. Increased productivity driven by employee motivation ultimately benefits both investors and the company.

✔️ Addressing investor dilution:

Equity compensation programs will result in dilution for investors. However, the value created by motivated and productive employees outweighs the dilution. By allocating equity to employees, founders can build a stronger team and enhance the company’s value proposition. Let’s consider the following: if one investor gets diluted by 10%, which makes employees become 50% more productive, he is much better off.

In more practical terms, early stage investors require an ESOP pool to be established from the founder shares. During subsequent rounds, next round investors usually require the ESOP to be “refilled” and all shareholders (including the existing investors) are diluted pro-rata.

✔️ What happens when an employee leaves the company?

In this case, there are two scenarios to consider with different implications on options.

The “Good leaver scenario” refers to an employee who leaves the company under amicable circumstances, such as retirement, redundancy, or for personal reasons not related to performance or conduct. In such cases, employees are allowed to keep any vested options. They can either exercise them, or depending on the ESOP’s terms, they may be able to hold onto the options for a certain period.

The “Bad leaver scenario” refers to an employee who leaves the company under less favorable circumstances, such as being fired for cause or resigning without a valid reason. In these cases, the company typically has the right to cancel any vested or unvested options that the employee holds.

✔️ The “buy-back” clause: The “buy-back clause” is a provision that can be included in an ESOP. It gives the company the right to buy back vested options from an employee when they leave the company, even in the case of a good leaver. The price at which the company can buy back these options is typically specified in the ESOP – could be the fair market value at the time of the employee’s departure, or predetermined when the options were granted. Including a buy-back clause in your ESOP can be beneficial for both the company and the employee. For the company, it provides a way to maintain control over its equity. For the employee, it provides a guaranteed buyer for their options, which can be particularly beneficial if the market for the company’s shares is illiquid.

Common mistakes in ESOP structures


📌 Inclusion of non-critical employees: Avoid including employees who can be easily replaced in the ESOP program. Focus on rewarding and retaining key employees who contribute significantly to the company’s growth.

📌 Percentage-based equity offers: Instead, consider assigning a low nominal value to shares. For example, offering 50,000 shares rather than 0.01% of the company helps employees better understand the value of their equity.

📌 Options/stocks in subsidiaries: Often, startups which are scaling open offices in multiple countries and award shares only in the local company. This, however, may backfire. Local managers may prioritize their own office’s growth over the overall success of the startup, leading to playing politics for resources. This also makes exits more complicated and puts founders at risk of being extorted for additional funds by local management.

📌 Options on preferred shares: Avoid compensating employees with options on preferred shares, as it puts them on the same level as new investors. Instead, provide employees with common stock to align their risk and reward with the founders.

📌 Deciding to take on the tax deductions of your employees: From a tax perspective, different countries have different requirements and companies should not strive to optimize employee taxes. Trying to manage taxes for many people from different jurisdictions with different tax brackets is very complicated and time consuming.

And as a final note, it’s important to remember that an ESOP is not a one-size-fits-all solution. But as you embark on your ESOP journey, keep these basic principles in mind to create a plan that not only rewards and retains top talent but also drives your startup’s long-term success.

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