An ESOP, or Employee Stock Option Plan, is a must-have for any startup. Whilst the size, terms, number of employees encompassed and duration, of ESOPs will vary between tech startups, the reasons for creating an ESOP will not.
From the early stages of the startup the founders will be very resourceful and handle the majority of the work, however, to ensure success, entrepreneurs will need to hire in order to grow. These initial hires will be some of the most important the company will ever make. Due to financial restrictions, companies will not be able to compete with established businesses for the brightest talent. That is where the ESOP is very useful.
In short an ESOP is a portion of the company’s share capital which is allocated to employees in the future as stock options together with the terms governing these stock options. These terms vary widely between startups and as there can be many technical and legal stipulations within an ESOP these plans should only be drawn up under the guidance of suitably qualified legal and financial experts.
The size of the share allocation governed by an ESOP will also vary between startups. The most common size of share allocation contained in an ESOP would be in the 15-20% range, but this varies based on cofounder expertise, industry sector, early hire skill set requirements and even geographical location (it appears that it is not uncommon for a San Francisco based startup to allocate up to 25% of its share capital to their ESOP).
Vesting is a key part of any ESOP and refers to the timeframe and schedule over which stock options become exercisable. Again, vesting schedules vary between startups but the main manners in which they differ are; overall length, time to first options being exercisable (the so-called “cliff”) and the regularity that subsequent options become exercisable. The time to the first options being exercisable is normally 12 months and means that the employee is required to remain with the company for at least a year before they can exercise their first stock options.
As the name itself suggests, the reasons for creating an ESOP all relate to one vital aspect of every startup: the employees. It is obvious that no startup can survive, let alone scale successfully, without a talented and dedicated team. Finding talent is getting ever more difficult as roles become more specialised. Having found the right candidate, and successfully onboarded them, then comes the long-term task of keeping that team member happy and productive.
It is therefore possible to condense the three main reasons for setting up an ESOP into a neat mnemonic: ARM. Attract. Retain. Motivate.
Attract: Qualified candidates are becoming harder to find. This is especially true for startups, particularly those in the early stages, as they lack the financial ability to offer salaries that are on a par with those offered by established companies. Two co-founders bootstrapping their startup simply cannot compete with the salaries offered by a company valued in the billions of dollars. So, how do these early-stage startups attract talented candidates? They do it by offering them a share of the startup, they offer the new hire some ‘skin in the game’.
Retain: Finding the right talent is difficult but retaining that talent, once found, is the key to any startup scaling successfully. This is the role of vesting. Allowing share options to become exercisable regularly over a number of years is akin to a regular loyalty bonus and incentivises employees to stay with the startup.
Motivate: As the employee owns, or will potentially own, some of the company, then there is an additional motivation to work harder to ensure the future success of the company. Having ‘skin in the game’ means that there is a clear and tangible reward for increased effort. ESOPs also create a sense of camaraderie amongst employees as they all work together towards a common goal of success and the notion that they will all share in the benefits of this success once it has been reached.
To ensure that a startup’s employees are talented, loyal and motivated it is imperative that a startup prepares themselves properly before beginning the hiring process. One essential step in this preparation process is to ARM themselves with an ESOP.
Dr Jonathan McLaughlin is an ICO Adviser at Flawless Consulting.
Jonathan holds both a Ph.D. and an MSc in Mathematics as well as a First Class BSc in Financial Mathematics & Economics. Jonathan has held Mathematics lectureships at Dublin City University and the National University of Ireland, Galway. He is a published mathematician and author, and holds UK patents. He is currently concentrating on his role at Flawless Consulting where he is an Ideation Analyst and ICO Adviser.
Emmet Creighton is an ICO Advisor at Flawless Consulting.
Emmet is a qualified Solicitor and holds an LLM in Law Technology and Governance, and a BL in Corporate Law. Emmet advises on digital assets, ICOs, cryptocurrencies and blockchain technologies and across other areas of specialism relevant to FinTech projects. He also advises on a wide range of regulatory matters, from legal compliance to establishing financial institutions in Ireland.