If you’re trying to decide between compensation strategies, “cash is king”. However, for both early stage companies where cash may not be readily available, and also to later stage companies in which employees are encouraged to think of themselves as “owners” of the company, it will make sense to offer access to an Employee Stock Ownership Plan or ESOP.
An ESOP can have a number of characteristics. Here are a few of them:
Paid/Unpaid Options: The employee can pay to receive options, the options may be granted automatically with the passing of milestones (financial or time-based) or the Board of Directors may be given discretion to grant options.
Payment for shares – determination of strike price: The “strike price” or price per share at which the option is exercised can be based on market value or anticipated market value at the time of exercise (as determined at the time of option grant). Market value at the time of option grant is preferable, because, presumably, as time passes, the employee’s effort had contributed to the increase in the market value. Where a company is a public company, generally there are rules that set out how much the grant of an option can deviate from the current market value, so as not to unfairly prejudice existing shareholders.
Rights of option holders: Typically option holders will have limited rights. Option holders usually do not have any shareholder rights in the corporation and thus, for example, would not receive any dividends before their options are exercised. Option holders are often unable to exercise their options right after the options are granted as they need to be vested which is usually spread over time. Finally, exercising of options may be governed by very stringent rules setting, for example, very tight expiry dates.
Result of termination of the employment agreement: Unvested options will typically be revoked. In some cases vested but unconverted options will also be revoked. In some cases the company will buy back shares that were purchased. In some cases a fixed price for buyback will be determined in advance (and this is typical for a company in which the ESOP is used to distribute excess cash, to provide to current employees the opportunity to share in company profits).
Dilution: ESOP is a pool of shares that is intended to benefit all employees. As a result, it is difficult to negotiate an anti-dilution clause. A company may run more than one ESOP program simultaneously so as to reward executives separately from non-executives.
Number of shares set aside for ESOP: While there are many ways to structure an ESOP, typically, five to fifteen per cent of the company’s issued and outstanding shares are usually set aside for the purpose of ESOP, but, further to the dilution point mentioned above, that may be distributed amongst various plans. The company should also consider allocating a larger option pool if it is in early stages of development. Doing this will allow the company to attract good talent at early stages.
Vesting: The company should carefully consider its ESOP vesting schedule. The company would want to provide options as an incentive and a reward for talented employees and advisors rather than as a source of financing. Short periods of vesting might be damaging to the company as its employees’ performance may decrease after they exercise their options. The company may wish to provide shorter vesting period for early stage employees as they assume more risk.