5 Things You Must Consider When Setting up an ESOP
In our last post, we looked at what goes in an Employee Stock Option Plan and how to set up one quick and easy on QuotaBook. There are a few things you, as startup founders, have to consider as you set up an ESOP. Let’s take a closer look.
1. Size of the ESOP Pool 📐
When setting up a company, how to split your equity pizza might not be your immediate concern. However, you always want to remember more stakeholders are bound to join as your company raises more funds down the road. You want to keep your share.
This includes what you give out to your employees. It is recommended that you set a limit on the percentage of equity to share with employees. In general, an ESOP pool is about 7.5 - 15 % of total company shares. 10% is most common, with each employee granted a right to buy around 0.5 to 3% of equity.
Note that as your company raises more funds and the total number of shares increase, the % of the ESOP pool remains the same. But because there is a bigger pool of total shares, the ESOP Pool will grow bigger as well.
2. Equity Dilution 💧
Equity dilution is when a stakeholder’s ownership of company equity gets smaller.
Let’s think of company equity as one big, giant extra large pizza and you have the cutter in your hands. And you have to decide how you will divide this pizza so that everyone is happy with their piece.
If you want more people in the party, you will have to give up some of your share to cut the pizza into more pieces. You can’t have the whole thing to yourself.
But as your company makes more ESOP plans, and more stakeholders join in, the founder’s share of equity will naturally decrease.
In the end, the founder may be left with a very small portion.
In the case of a company exit, this situation could get quite tricky when a host of people share the equity pizza.
This why board of management can include drag-along rights, to allow specific shareholders to force minority shareholders to sell their shares upon receiving a third party offer.
3. Exercise Price 🏷
Exercise price, as explained in our previous post, refers to the price an employee has to pay to exercise their vested options within a set time frame. Not all employees have the same exercise price.
How do you determine the exercise price of stock options?
There are broadly two ways to go about deciding the exercise price.
Set it to the current market value of company shares.
How? Set exercise price to the market price of the company shares at the time options are granted to employees.
Refer to the valuation from the latest funding round.
Go with a nominal exercise price.
How? Set exercise price equal to the nominal value (aka par value) of each share.
*Nominal value is a random value set for balance sheet purposes when a company issues share capital, usually less than $1.
Employees will benefit if the company value increases from the date options are granted, reaping more gains from selling their shares.
4. Vesting Period ⏱
Most ESOPs will have a vesting period of 3 or 4 years. As a reminder, vesting refers to the process in which employees earn their shares over time. Read more about vesting in our last post.
Vesting incentivizes employees to stick around longer by setting a time frame during which the amount of exercisable stock options goes up. You might want to think about the right vesting length to best incentivize an employee considering each of their role and employment duration.
For employees who joined the company in the early days for example, you might want to set a shorter, more flexible vesting period to motivate them.
5. What will happen when an employee leaves? 👋
You also want to consider what will happen when an employee leaves. Will they lose all of their unvested shares? Will you move up the expiration date, the latest date by which the employee can exercise their options?
An expiration date typically aligns with the time frame for a company to find an exit. This period will typically range from 7 to 10 years from the grant date, while it will vary depending on the company’s stage of growth.
If an employee leaves, you may leave the expiration date as it is or give a shorter time frame, depending on the needs of the company.
Got Questions on ESOP? Talk to us!
Start Today and Try First 3 Months Free.
※ Legal disclaimer
Make Equity Complete — QuotaBook is a global equity management platform with a mission to create an ecosystem for private companies and their investors and employees. Leaving spreadsheets and manual works behind, every stakeholder can connect online and sync crucial data on equity such as cap table or employee stock options. It is the leading platform used by top startups and VCs in Asia, backed by Y Combinator.
This piece is written for information purposes only and is not intended as financial or legal advice. QuotaBook does not assume any reliability for dependence on the information provided above.