All you need to know before implementing ESOP in your start-up

Frequently, start-ups are unable to provide salaries as high as those offered by larger, established companies on the market, thus, they created other interesting benefits. ESOP is that type of bonus scheme to motivate talented employees to choose to work for start-ups, stay loyal and become part of the success story.

Different forms of ESOP

The option plan is the most popular type of ESOP used by start-ups. Essentially, the employee signs the ESOP agreement and does not receive actual shares, only the rights to buy the shares in the future. Shares can only be obtained after working in the company for an agreed period and meeting certain conditions. Employees feel they are part of the company, but in reality, they aren't.

Reverse vesting, another form of ESOP, means that a start-up grants an employee actual share of the company. It is crucial to have a well-crafted contract that outlines the mechanisms for resolving various situations that may arise, such as when an employee leaves or is terminated.

Phantom shares are established through a contract between an employer and employees or subcontractors. A start-up doesn't grant the employee real shares either at the time of contract signing or in the future. Employees only receive benefits similar to those of actual shareholders. For instance, in the event of a company sale, employees receive bonuses as they would if they held real shares, but they are never shareholders themselves. However, this income is taxed as regular income.

Optimal size of ESOP

The optimal size of ESOP varies between Europe and the USA. European start-ups typically establish their ESOPs at a maximum of 10%. In contrast, particularly in the US, the figure starts slightly above 10%, approaching 20%.

Another distinction between Europe and the US is that in the US, ESOPs are created even at the seed stage, at around 10%.

What do the terms like strike price, grant, or cliff mean?

As the option plan is the most popular form of ESOP, let´s dive into the term that are crucial in the ESOP agreement, and it is important to know what they mean:

Strike price is the amount paid by the employee for the share at the time employee decides to exercise the option. This price is negotiated when the ESOP contract is signed and generally does not change even if the market price of the share increases over time.

Grant is the final percentage of the shares employee gets after certain years. The value of the grant generally corresponds to a certain proportion (generally up to 1%) of the annual salary cost of a particular employee and the post-money valuation of the start-up at the time of signing the ESOP agreement, adjusted by a coefficient which is determined by the seniority, the employee´s field of activity as well as the company´s business.

Vesting is the period during which an employee gradually (usually 25% per year) acquires options for the offered shares in the company. It means the vesting period is the number of years, usually 4 years, an employee must work for the company to acquire the right to the option. At the end of the vesting period, the employee has the right to purchase all or part of the shares to match the size of the grant.

Cliff is the minimum period that must elapse for the employee to become entitled to a portion of the target number of options. For example, it can be used for the first year of the employee, when it is not sure it, he or she fits the company.

Exercise period comes after the vesting period when the employee is entitled to use the option to exchange for the real shares at the strike price. Employees must use the option and buy the shares during this exercise period, otherwise they lose the right to buy. Usually it is 6 years, but in case the employee leaves the start-up or is terminated, it shortens rapidly on average from 60 to 90 days.

This article was prepared from the content of the Spring Accelerator´s lecture with Peter Pašek, Managing Director & Partner Accace Slovakia & Co-founder of AceON Accelerator.

May 10, 2024

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