In every jurisdiction there exist a multitude of employee incentive schemes, to offer stocks to individual employees. In some countries, these are referred to under the umbrella term “Employee Share Scheme” or “ESS”, for short. Many of the methods under this umbrella involve issuing stocks directly to the employee.
However, the best way to grant equity (or ownership) to an employee or contractor, is usually via what’s called an Employee Stock Ownership Plan (ESOP).
So, what is the difference between an ESOP and a direct issue of stocks?
We’ll answer that question in this article.
How does an ESOP work?
An ESOP is a type of an employee incentive scheme. It offers ownership to employees and contractors, subject to vesting requirements and ongoing rules.
In short, an ESOP works as follows:
- the employee or contractor receives options (or rights),
- to receive ordinary stocks,
- as long as she/he complies with the rules of the ESOP (Plan Rules).
ESOPs are the most common form of employee incentivisation for small and start-up businesses.
What’s the difference between an ESOP and a direct issue of shares?
The key difference between an ESOP and a direct issue of shares, is that under a direct issue of shares, the employee receives stocks upfront.
Under an ESOP, the employee is only granted options, which can be converted into stocks once they have satisfied their vesting conditions.
Why would I do an ESOP instead of directly issuing stocks?
ESOPs are the most popular method of granting employee ownership for start-up companies.
The main reason for this is that they are often easier to set up and manage. They require less administration – music to a founder’s ears.
We’ve summarised the reasons for this below.
No need for stock buy-backs where vesting is not satisfied
Under a direct issue, the employees are issued stocks up-front, that are subject to vesting requirements (for example, the employee has to stick around for a certain period of time to earn a certain amount of those stocks).
If the employee does not satisfy the vesting requirements for certain stocks, then the company is able to buy-back those ‘unvested’ stocks at a nominal value (for example, at $1).
However in practice, this can get quite messy.
If, for example, a company offers stocks to 10+ employees, and only 5 of those employees actually satisfy all of the vesting requirements, then the company would be required to conduct stock buy-backs for all of the employees where the vesting criteria was not met.
While lots of this can be automated in Cake, it can still be a time consuming process, as it will require cap table updates, members resolutions, buy-back agreements, and updates to relevant regulatory bodies, for each buy-back.
ESOPs can recycle lapsed options – no regulator updates required.
Comparatively, under an ESOP, where an employee does not meet the vesting requirements, the options will simply lapse.
They can then be recycled into the option pool to be used for further offers.
Cake can do this with the click of a button. It is as simple as where the employee has not satisfied her/his vesting criteria, hit ‘lapse options’ and they will be back in your pool and ready to incentivise other staff.
Clearer dilution figures
Under a direct issue of stocks, the cap table is updated with the stocks issued. When you are doing your capital raise preparation, this can cause some confusion for potential investors.
For example, working out which stockholders have stocks subject to vesting criteria and buy-back rights, and which stockholders own their stocks outright, may not be immediately clear.
With options, however, they are displayed in a separate ‘option register’ until they are exercised. This provides a clear overview of the ownership structure of the company.
Cake will also automate the dilution calculations of all options issued, and clearly display the vesting timelines of all options granted.
No up-front payment required from employees
Under a direct issue of stocks,, the employee may be required to pay at least 85% of the stock’s fair market value up-front.
Under an ESOP, the employee is usually only required to pay the Exercise Price when they exercise (or convert) their options to stocks, after they have met their vesting conditions. Often, they won’t actually exercise their options until there is a clear motivation to do so. For example, they will exercise when the company is about to go through an exit event.
Having no up-front payment can significantly improve the incentivisation when the offers are made. All they have to do is accept it, and get to work.
No voting or dividend rights until options are exercised
Under a direct issue of stocks,, the employee will become a stockholder, just like any other ordinary stockholder, from the start. This means they will get voting rights and rights to dividends (if declared).
Under an ESOP, the employee only gets these rights once their vesting has been satisfied and they have exercised their options. This means they technically need to earn those rights, and only the employees that work hard and stick around will get them. And again, often they won’t exercise their options until an exit event is likely anyway.
This can make it easier for the company to move quickly. They won’t need to get stockholder approval from the small employee stockholders for ongoing matters. Agility can be key.
Want to get started?
Cake has streamlined the ESOP process, from
- implementing the option pool,
- adding your Plan Rules,
- creating the offers and
- getting it all signed.
The platform can also automate vesting, where it will track the buy-back rights of the company.
And if you want some friendly assistance, let us know and we will put you in touch with our start-up lawyer partners. They offer free initial consults, and use the Cake platform to guide you through the whole process.
If you liked this article, check out Employee Stock Plan Jargon – All the terms, in simple terms or What is an Employee Stock Option Plan, and why bother?
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.