The beginning of any startup company is a fast and furious drive to build value across a broad spectrum of company assets.  The most important asset a company has is its human capital.

Most Tech startups are cash-poor with big dreams, and unconquered markets before them.  After all, people don’t start many IT companies to fixed problems that do not exist.  For cash-strapped organizations looking to attract quality employees, an Employee Stock Options Plan (ESOP) offers an avenue to building a superior team without breaking the bank.

The role of an ESOP in startups is of immeasurable importance in the development of high growth sector industries. In addition to understanding the important role this option plays in the development of a quality employee pool, it is also critical to appreciate the positive and negatives aspects.

It is rare to see a series A round of financing not include a set aside (from the common shareholder’s equity) for an ESOP.  Venture Capitalists know that it represents the carrot for attracting new highly qualified team members to the organization.  The size of the ESOP as a percentage of the company varies, but 20%-25% is not uncommon.

The Role of an ESOP in Startups

The role that an ESOP plays has shifted in recent years as the number of new companies chasing experienced executives for IT company roles has increased. At one point, employee stock options were the rewards of senior employees for a job well done, but now they’re an accepted employee attraction and retention tool. Under this new usage, employees are allocated a number of share options.  Typically, employees must wait a certain amount of time before they can exercise their options, thus the retention element. Known as a vesting period, employees essentially earn “sweat equity” in the firm while the company builds value in the formative period. A common vesting schedule is four years:  25% of the options granted can be exercised on the first anniversary of their hire, and 1/48 of the remainder vest each month thereafter.  Options should be set to expire, usually within 90 days of the employee leaving the company.

To the company, it can consider Options to be a form of deferred income.  Rather than spend thousands of dollars attracting quality employees, employers can entice these potential workers with the promise of a future ownership stake, where their hard work and effort results in the value of the options being considerably more than they would have otherwise earned.

The Upside to Offering ESOP

In addition to the benefits as a recruitment and retention tool, an ESOP provides a source of motivation for employees who gain an ownership stake based on the shares they earn in the company. Rather than feeling like an employee whose responsibilities end when they clock out of their shift, option holders really are owners.  Accordingly, they should be more motivated to work to see the business thrive.

As a recruitment tool and employee motivator, Employee Stock Options Plans is the new way startups are moving the needle on employee enthusiasm.

The Downside to Offering ESOP

While the use of Employee Stock Options Plans offers tangible advantages to both employer and employee alike, the mechanism is not without potential problems for each party. In the case of the employer, they risk losing company value on major decisions, based on voting-rights agreements.  While the options have no voting interest until they are exercised, if the pool is set at 20%, and the investor has a stake greater than 40%, the entrepreneur may no longer be the majority shareholder.

For example:

        Investors:               45%
        Option Holders:   20%
        Entrepreneur:      35%
        Votes:
        Investors:               45%   {56.2%}
        Option Holders:      0%
        Entrepreneur:      35%   {43.8%}

 

So effectively, the entrepreneur has lost control in majority vote scenarios where all classes vote as one.  In a previous company I set up the ESOP so that those shares automatically voted with the majority of commons shareholders.  This allowed me to maintain control longer.  An ESOP offers far more upside than downside.  As a matter of fact, if the voting issue ever arises, and you as the entrepreneur did not plan for how they vote, the company has a lot of serious problems to address.

This is not uncommon.  Also, many financing documents call for the option pool to be automatically “topped up” to 20% on a continuous basis.  As the pool generally is composed of common shares, this dilution affects the entrepreneurs much more dramatically than the investors.

For the employees, there are risks as well.  While the employee is essentially “betting” that their stock soars and makes up for accepting lower pay in the short-term.  This is particularly true for those who accepted a large grant options in lieu of their normal  salary; If the company doesn’t do well, then they will not be worth anything when their time to cash in arrives.  In fact, there won’t be any cashing in; buying the options would be a loss…

But, we all hope for the best, and option holders are betting that their company will be the one-in-ten startup that actually becomes successful.

I would not start a software or SaaS company today without offering an ESOP.  While I may recommend a profit sharing plan for some companies, an ESOP is one of the “required” elements in the entrepreneur’s toolbox.  Plan for it.  Get it in place early.  I recommend dealing with it prior to your first round of funding.  In doing so, the entrepreneur and not the investor gets to control how it is set up, and how they vote.

Some entrepreneurs are loathe to invest in the legal fees to set everything up early in the company’s life.  This is understandable.  Cash is hard to come by, and it is not viewed as a necessary expense.  If the company is not hugely successful, they made the right call.  But if your company is really going to raise capital, documenting your plans, and sharing those documents become precedent, and demonstrate intent.  Take the time to do it right.  Done right, it will not cost much, and will save you a tremendous amount in the future.

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