Welcome everyone to another edition of the blog. Today we are talking about how companies use equity to motivate employees at early stage tech companies.
In fact, ESOPS are often one of the first times that founders will finally stop doing things themselves (I'm not bitter, I get it, we cost $), and reach out to formally engage lawyers to help them on their company operations. Founders are usually looking to properly incentivize their employees, but not sure what is common practice on how much equity to give, how to allocate it among different types of employees, and the pros and cons of different types of equity to offer.
One point of confusion sometimes - I usually get asked to help put together an “ESOP” for a company. I stopped correcting people on this a long time ago, but technically an ESOP is an Employee Stock Option Plan but in fact many founders use the word ESOP to mean any kind of employee equity arrangement, not just for options. More on that below.
For these early stage companies, we don’t typically need to build out a robust 20 to 30 page “Plan” with a separate award document listing the number of options to an employee. That is better suited for at scale when an organization is more mature and the employee count much higher. In the beginning, many of the core terms discussed below can instead be rolled into a simple award agreement of a few pages.
Okay, on to the main discussion. In this post, I’m going to set out both the technical differences between different variations of ESOPs and also what is considered common practice.
AWARD AMOUNTS
Technically, the shareholders of a company authorize a total pool of equity to be issued, and the board decides how that pool is allocated. The total pool size available to be awarded to the employee group is often about 10% of the total equity in the Company, but can be as high as 25% or 30%, particularly if there is only one founder who will be leaning heavily on key employees early on.
It is worth noting that more and more founders are setting up an ESOP at a very early stage in the company’s life, especially here in China and Asia as well. This makes sense especially for companies which are high growth and equity will be a key incentive to attract talent, and given that a Series A investor coming into the company will in any event require, as a condition to their investment, that the company set up a proper ESOP pool.
For early stage companies, upwards of 50% to 75% of the total ESOP pool may be given to key employees like the head of sales, CTO, etc., and another 10 to 20% given to other important employees.
Founders may also participate in the ESOP in addition to shares they may already have in the company. Experienced founders - to keep each other honest and fully engaged - may also proactively put each other on a separate vesting schedule for their entire shares in the company. This is also something their first major outside venture capital investors may ask for as well.
Before you start thinking what an injustice this is, remember that the shares held by founders in many ways represent not just work they have done to date to get the company where it is (inning 1 or 2 of a 9 inning game), but work that needs to be done to keep building it. Its a down payment on future (below-market wage) service to the company and no investor would invest in a company if it knew the founders were looking to leave in the next few months.
TYPES OF EQUITY AWARDS
What kinds of equity incentives are given?
Options
First, there are options - the most common type of equity when people tend to hear about ESOPs. Options are the right to buy shares in the company at a future date and a set price. We call that set price, the “exercise price” or the “strike price.” Employees usually prefer outright share awards rather than options because for options, you have to pay a certain amount to exercise your option as an employee.
Options do not have any voting rights in the company until they are exercised for shares, and as discussed later, sometimes those shares may still have voting restrictions on them.
Restricted Shares
Restricted shares are issued to employees, but they are subject to certain vesting timeframes and vesting conditions. The shares can be given outright to key employees with no vesting period, but often companies put conditions where the company can take the shares back.
RSUs
There are also restricted stock units or “RSUs”. They are given to employees entitling the employee to a certain number of shares at each vesting schedule date. The key difference between RSUs and restricted shares is that for RSUs, the shares are not yet issued until each vesting date.
This is most relevant as a forfeiture of unvested RSUs just lapse when a condition is not met (for example, an employee’s departure from the company), but forfeiture of restricted shares need to actually be transferred back to the company and transferred off of official shareholder records.
RSUs tend to be more complicated and made part of a full ESOP plan and are offered typically more for later stage pre-IPO and post-IPO companies.
Phantom Stock (Virtual Stock)
Phantom stock is more common outside of Asia, but is becoming more and more prevalent here as well. With phantom stock, employees do not actually ever hold shares. They just hold phantom stock or virtual stock that basically gives the employee an economic right. Basically rather than shares, the employee has a contract with the company for certain future contingent bonus payments. For example, a certain percentage of the profits of the company allocated as if to mimic the employee being a shareholder of the company without actually ever being a recorded shareholder.
Stock Appreciation Rights
Stock appreciation rights are sometimes given as well – basically a contract where the employee enjoys a portion of the benefit of the rise in value of the company during a certain period of time. But these again are offered typically by more mature companies, especially public companies, because it's much easier to issue stock appreciation rights and calculate their value with a publicly traded stock price. Most pre-IPO companies will not use stock appreciation rights.
EXERCISE PRICE
For public companies, the exercise price of options is often based on the current market value. But for private companies, it is hard sometimes to determine what is the market value of the company.
For later stage companies, you might set the exercise price as a function of the last venture capital investment round. Similarly, public companies have a publicly traded share price to benchmark for setting the exercise price at the time of option award.
Sometimes instead of the market value, you may want to give an extra benefit to the employees by having a discount off of the market value, including simply a nominal value.
With low exercise prices on options, the employee gets some of the benefits as if he or she had been given shares, but they are not actually a registered shareholder yet. There are potentially tax issues related to how you price the options and the benefit to the employee and whether that is taxable.
VESTING PERIOD
We have alluded to this already. It is quite common for equity to be granted using a vesting period – meaning the employee forfeits some portion of the equity if he or she leaves before completion of the vesting period. Within the vesting period, it is also common to first have a “cliff”. A cliff can often mean that no equity is vested until a minimum amount of time is met, often after the first year. Then after the first year, the remainder continues on a typical vesting schedule.
An example - you might have a four year vesting schedule where 1/4th of the equity is vested after the first year and another 1/4 in the second year, third year, and fourth year. You may instead have a cliff where nothing is vest until the end of the first year, but then after the first year vesting occurs pro-rata on a monthly basis up until the end of the vesting period at year four. This is to make sure the employee stays on board for a minimum amount of time (1 year) but then doesn’t penalize the employee for leaving mid-year after that.
EXPIRATION PERIOD
In addition to a vesting period, for options you will also have an expiration period. So the option is vested and yours to use, but you must use it within a certain period of time after it has vested. For example, the employee would be forced to decide to exercise or not upon departure from the company if leaving on good terms.
You may even want to compel the employee to decide within a certain period after the options vest whether or not to exercise those options to become shares. For the benefit of certainty on your cap table.
FORFEITURE AND COMPANY BUY BACK
Employees may also be required to, for example, completely forfeit options or shares if they are terminated for cause (what is known as a “bad leaver”). Although less common, some companies may even require employees to forfeit all of their options or shares (even the vested ones) if they leave the company even voluntarily. Yeah, this is a bit harsh but it does happen on occasion.
Less draconian, the company may instead have a right to purchase those options or shares at a discounted price back from the employee or pre-agreed valuation formula (e.g. a multiple of company revenue). This makes sense as companies do not necessarily want the employees who are departing to keep equity in the company. That equity could be better served to award to other employees who are still at the company to incentivize them.
Remember of course, especially as it relates to those bad leaver forfeitures, it is very difficult to terminate employees for cause in China, so termination for cause forfeiture clauses need to be carefully considered and drafted.
ACCELERATION OF VESTING
If there is an acquisition of the company, the employees will likely be required to sell any vested shares or options under the terms of their award agreement or shareholder agreement with the Company. The employee will also typically have unvested shares or options accelerate and become vested immediately prior to the closing of the sale of the company.
While this is a bit of a windfall of course, for the employee, it is also done to incentivize the employee to participate and to facilitate the closing of the sale of the company. Employees might hear of the impending sale of a company or be directly involved in responding to due diligence inquiries, and the founders and other shareholders of the company will want those employees on board with the sale rather than being a thorn in the side during the acquisition process.
As this post demonstrates, there are a lot variables to deciding which type of equity to offer employees in your company and under what conditions. ESOPs are becoming more and more popular for early stage companies, especially here in Asia, as another tool to let employees have more “skin in the game” and incentive to help the business grow. Not every company needs an elaborate plan with all the permutations I laid out above. But some sort of ESOP will make sense for most startups, especially high-growth ones.
Note we did not even get into the issue of how Chinese citizen employees hold options and shares in an overseas company. That is a complicated topic for a whole separate future discussion.
That’s all for this post today, thanks for reading, thanks for subscribing, and see you again in 14 days.