Let’s start with the basics.
What is an ESOP?
ESOP stands for Employee Share Option Plan.
An ESOP is a method of offering equity (or ownership) to an employee (or contractor), over a period of time.
An ESOP is a type of an Employee Share Scheme (ESS). However, the difference between an ESOP and an ESS is that in an ESOP, the employee initially receives options, instead of shares.
At a high level, an ESOP works as follows:
While there are multiple variations of Employee Share Schemes around, ESOPs are the most common form of employee incentivisation for small and start-up businesses.
Where an ESOP is provided under the ‘Start-Up Tax Concession’, it can provide a tax efficient way for employees to be rewarded for their efforts, and can allow an employee to benefit significantly from any increase in the company’s value over time.
Why should you set up your ESOP now?
1. Retain talent when you need it most
If you have talented people on your team, now is an important time to make sure they will stick around. While it is true that there may be a lot of applicants for jobs in a recession, it doesn’t mean that it will be easy to replace talent.
Additionally, hiring during a downturn can really cause disruption to the business where all hands are needed on deck.
Most ESOPs are subject to vesting rules that encourage employees to stay with the Company.
For example, the standard vesting conditions are that the employee needs to remain engaged
2. Attract talent among the noise
If you are in a position where you need more staff, it can be difficult to attract the right person.
Not many start-ups can lure talented staff with high cash salaries and corporate bonuses (shock horror).
By including options as part of a remuneration package, not only are you able to attract staff that are seeking higher pay, but you can attract staff that are joining the company with the end goal in mind – increasing company value and scaling.
While offering high cash salaries can encourage talented ex-corporate staff to get on board, it doesn’t mean they will be incentivised to stick around. Where they are keen to join the team and to be offered options, it is a good indication that they believe in the company and the vision.
While luring corporate talent to your start-up with a beach side office may be one approach, options can be a pretty powerful (and perhaps more realistic) alternative.
3. Substitute pay-cuts in a meaningful way
No founder likes making pay-cuts. However unfortunately for some companies in hard-hit industries, some have not had a choice.
Where you are forced to reduce the salary of staff to weather the stormy economic conditions, you can ‘top-up’ their packages with options. Not only does this allow you to get all of the other ESOP benefits, but it allows the employee to feel equally valued by the company.
It may also increase employee trust and respect in the founder/CEO, with the employees recognising them as a team-focused leader. Sharing is caring.
Additionally, this ‘top-up’ may in fact end up better off for the employee anyway, largely due to the tax concessions that can apply.
4. Early bird gets the worm
While it is true you can always hold off on setting up the ESOP until you are ‘more established’ or ‘the time is right’, it will actually be administratively easier to set it up early.
For example, if an option pool isn’t already permitted by your shareholders agreement, you may need to get shareholder approval to implement it. It is best to do this while your cap table is small.
Investors in Seed Rounds will often also want to see that you have an ESOP accounted for in your cap table (and perhaps also that you have already made offers to the key employees). They appreciate the value an ESOP can provide to a motivated start-up. It is logical to get the ESOP organised before the raise round, as we all know there is enough to do to prepare for a raise already.
And lastly, just because you set up the ESOP now, it doesn’t mean you need to allocate all of the options right away.
For example, if you set up a 10% option pool, you can just start with making offers in respect of 2% of that pool for now, and save the rest for later.
5. Let your employees start thinking like founders
This one goes without saying. The sooner your employees start thinking like company founders (rather than employees), the better.
During bumpy economic conditions, being innovative, agile and resilient is extremely important.
Once an employee starts working for the greater good of the company (rather than just for their paycheck), these traits will naturally come to life.
Options encourage innovation, collaboration and creativity. Motivate your employees to see the end goal.
Cake makes equity easy
Cake allows you to:
You can also purchase fixed fee legal packages to run the ESOP for you from start-to-finish.
If you liked this article, check out What’s the difference between an ESS and an ESOP? or Employee Share Option Plans – What happens when an employee leaves?
This blog is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.