If you’re a founder and trying to set up an ESOP plan for the first time, you sure are going to wobble in the maze of ‘where do I start with this process?’ Besides mastering the umpteen ESOP jargon, one must also determine which variables to include in an ESOP plan to attract and retain top talent.
Thus, it is not surprising founders grapple with a range of unclear questions. Not to worry, this blog aims at four essential points to consider before setting up an ESOP pool. Let’s get started.
Four Points to Consider Before Setting Up an ESOP Pool
Employee stock ownership plans (or ESOPs) are vital tools for startups when funds are limited. That said, not every ESOP is the same. This guide outlines the main commercial questions you should check to make things easier. For further guidance about adopting an ESOP, please read our guide on setting up an ESOP.
1. The pool size
Although it is the most subjective decision a founder has to make, a range between 0 to 15% is widespread. Some firms offer as high as 30% pool sizes. So the median figure is 10% which most founders consider. When in doubt, go with the 10% rule. Again, it is a subjective decision.
Even though founders generally shoulder the dilution from establishing an ESOP pool, investors do not. For instance, if ESOP is part of a capital-raising transaction, your investors may have specific requirements.
Even if the ESOP is not yet operational, an investor’s agreed stake in the company will be calculated based on fully diluted shares based on the ESOP pool.
As a result, it’s critical to ensure your ESOP pool doesn’t exceed what you presently need for hiring. The reason – the founder is responsible for paying that chunk of equity. Contrarily, it is crucial to have an adequate pool to hire and retain the talent needed.
Srikanth Iyer, CEO of HomeLane, seconds this thought. On a webinar, he recently discussed the benefits of creating a large-ish ESOP pool at the beginning and extending it over time.
2. ESOP coverage
It is a common question many founders struggle with – who should receive ESOPs? Is it the founding team? Is it senior management? Can it be a majority basis?
Or should it be given to all? While the answer may change over time, broad coverage (to all employees) signals the founder’s intention to share wealth with all employees.
It is essential to cover those who know what is at stake, failing to do so would be counterproductive and would undermine the plan’s purpose. Moreover, employees may not want to invest in uncertain assets; instead, they would prefer cash.
This decision relates to the existing pool. It is possible to maintain a limited pool for a more extended period or a larger pool for a short time. However, as an incentive instrument with a long-term perspective, maintaining the pool over a more extended period makes sense.
Never get carried away in the initial excitement and later battle sustainability with an insufficient pool. It is much easier to increase the pool than to discontinue an incentive.
3. Vesting schedule
The ecosystem seeks two ways to determine vesting schedules. One is to make vesting equitable, and the second is a gradual schedule.
Can an employee convert their stocks into shares right away? So, a vesting schedule should let employees accumulate stock to accrue more options.
If an employee leaves before fully vesting, they retain their ownership rights to the vested portion.
Over the last few years, alternative models have thrived that focus more on hiring than long-term retention. Additionally, employees consider job-hopping when the company’s growth prospects aren’t promising.
In addition to securing employees for hire, companies now need to structure stock options to encourage long-term retention.
Many founders opted for equal vesting over four years, while others considered monthly or quarterly vesting frequencies along with the former. A firm can choose from a variety of vesting options, including:
- Four year-equal vestings, zero exercise price, and no cliffs
- Four-year vesting and a monthly option
4. Exercise period
The exercise period is a critical component of an ESOP policy. It determines the joining decisions of employees. A policy requiring employees to exercise their options within 0 to 6 months of leaving the company may be a punishment. The employees would be required to use their own money for this purpose.
If the exercise period is short, the employee may lose their vested options rather than paying the exercise price and perquisite tax because future liquidity is uncertain.
With an extended period, exercise will correspond to a liquidity event. Thus giving the employees the required cash to pay the strike price and perquisite tax.
ESOPs might be common for every startup, but the implementation varies with founder and investor needs. Setting the right pool size, deciding on the ESOP coverage, determining the vesting schedules, and drafting exercise periods are four focus areas for starters.