As a startup founder, you may be considering the possibility of offering ESOPs, Employee Stock Ownership Plans, to your team. You know that they can be beneficial when hiring new employees, but what can they mean for your startup in its foundation stage? Here are some insights that we’ve discovered through our work with the #AccelFamily.
In this blog post, find out:
- How to look at and structure ESOPs as a startup
- How to evaluate the value created with ESOPs for both founders and employees
First, let’s begin with the basics. ESOPs are one of the components that organisations use to attract, engage, and retain talent. They form a major part of the founder’s compensation philosophy; some firms believe in providing stock options as part of their rewards system. Historically, providing stock options is not just practiced by startups, but also by bigger, well-established companies. For example, large banks have been known to distribute their equity and publicly traded companies have long used ESOPs as a retention tool. With a little flexibility, this approach can easily be applied within a startup ecosystem as well.
This is the thumb rule: if you have an engaged employee who wants to be wealthy, you need a strong and rigorous compensation plan.
Building an Effective ESOP
When building a compensation plan, it’s important to look at five fundamental axes.
1. The Equity Pool
At its core, ESOPs are the financial manifestation of a founder’s beliefs. If they truly believe in creating wealth for their employees, even a mental model of equity development can aid their hiring and compensation practices. As soon as an entrepreneur establishes their company, their equity pool must be ready to hit the ground running. If you’re interested in providing stock to your employees, start allocating employee equity pools, founders pools, and co-founding team pools at the very beginning.
What is your equity pool? What will you earmark for employees? Those are important questions to ask before you offer stock options.
Through our insights here at Accel, we’ve determined that if a founder is really looking to generate wealth and retain talent, they should set a double digit equity pool rather than a single digit one. Wealth creation happens with a larger pool so do not restrict your employee’s ability to generate wealth. However, it ultimately boils down to the entrepreneur’s corporate philosophies.
If a founder is really looking to generate wealth and retain talent, they should set a double digit equity pool rather than a single digit one.
2. The Stage of Your Startup
The ESOP pattern needs to evolve during the course of your startup journey. In the formation stage, founders are looking to attract 5 to 10 employees who will build the foundation of their team and generate value for their company. It’s also critical to note that early-stage employees are taking a large amount of risk to join you, and hence, need compensation through ESOPs in a much more rewarding manner in comparison to the reward in the growth phase.
In general, after you’ve decided how many and what kind of employees you would like to hire, consider a plan to execution system. Find and evaluate data accurately to understand what a good stock price option is at this stage to attract potential talent. (Unfortunately, if there’s a 100% diversion from the data, you may not generate enough value for the employee).
3. Value Creation
ESOPs are a mutually beneficial compensation tool: engaged and motivated talent that believes in your company’s vision is likely to generate more value for you at any stage. Simultaneously, this also generates wealth for the employee, rewarding them for their risk and hard work. Once you reach the validation stage after you’ve found your early stage employees who truly believe in your brand and can drive it forward, it is best to narrow your focus. Segment the organisation’s value contributors into three main groups: leadership positions, management and tactical positions, and individual performers. Continue to mold your ESOP from there, sculpting the program as you scale.
At the foundation stage, reward your employees for their risk and hard work. Then offer ESOPs to those in leadership and management or tactical positions, and individual performers.
4. Employee’s Salary
The stage of the startup and the company’s ability to pay higher salaries converge at this point. At the validation stage, acknowledge that the firm’s ability to offer compensation is likely to increase, whereas the ability to offer equity will decrease, and tweak your rewards model as needed.
5. The Vesting Period
A vesting period is one of the attributes of an ESOP. This is when an employee is given the number of options for stock tenure, which could range between 1 year for performance units, or 4 years for cliff-vesting or linear-vesting methods. The key is to base the offered vesting period on what component of the compensation plan is extended. For example, some startups have introduced accelerated vesting which is dependent on the employee’s performance. In this case, instead of waiting 4 years to vest, the stock option vests at the end of the calendar year or 365 days.
From the Employee’s Perspective
Wealth only gets generated when an employee can exercise their stock options. From their point of view, strike price and buying price play a valuable role in defining what their wealth creation looks like.
There are multiple different stock options and formats, such as RSU (Restricted Stock Unit), a zero value option that is distributed at the current price when an employee joins. But let’s look at an example to demonstrate the influence of price.
When the startup is first established, the value of an ESOP may stand at 1 dollar. When the company moves from the foundation to the validation stage, your stock option price increases to 12 dollars. When an employee joins the company, depending on the valuation of the company per unit, he will be given 12 dollars. This means the company needs to move to anywhere between 15 to 28 dollars for the employee to actually generate profit. This is why joining early matters, as the difference in value builds up.
In this context, if an employee joins when the price is 12 dollars, and, for instance, the company gets its next round of fundraising or the employee leaves, coupled with an increase price per unit at 18 or 19 dollars, the threshold is around 6 dollars. 6 dollars is the profit the employee makes, while he needs to pay back the 12 dollars. That’s why the strike price plays an important role — with a zero value stock unit or RSU, which is offered to the employee at a price of zero, the employee’s benchmark could be at 18 dollars as compared to 6 dollars in both formats.
Now, when it comes to evaluating the best time for an employee to exercise his vested period, it depends on the type of stock compensation offered. If they were offered a stock option at zero, they do not need to pay tax on it and can keep it for as long as they would like to. However, when the unit is priced at 12 to 18 dollars per unit, then the tax bracket kicks in, which means the employee will have to buy in the day he leaves the company to make sure the unit is with him until the next strategic buyout happens through an IPO or secondary sale.
ESOPs — The Bigger Picture
Offering an effective compensation plan could be the difference between hiring mediocre employees versus hiring highly effective, driven individuals who can add real value to your startup. Because the crux of every startup success story is a strong binding force between the firm’s founders and its employees, ESOPs can be the strategic mechanism to build that cohesion, creating shared wealth in the process. They foster accountability on both sides — employees accelerate past their potential in order to build the best company possible, while founders ensure equitable compensation within the organisation. Simply put, everyone wants to be wealthy; ESOPs are just the device to fulfill that desire.
Our actionable insights:
- Develop an equity pool at the very beginning of your startup journey; create a double-digit equity pool rather than a single-digit one
- Be flexible with your ESOP pattern as you grow — your ESOP offerings should look different at the foundation, valuation, and growth stages
- ESOPs should create value for your employees in the form of wealth generation; use them as a rewards tool
- Tweak your ESOPs model as your ability to offer higher salaries expands and your equity capacity narrows
- Base the offered vesting period on what component of the ESOPs compensation plan is extended to your employee