What is an Employee Stock Option Plan, and why bother?

An Employee Stock Option Plan (ESOP) is a method of granting equity in a business to an employee over a period of time. It really is as simple as it sounds – the employee receives options (or rights) to be granted real stocks in the business, as long as they comply with the rules of the ESOP (Plan Rules).

While there are multiple variations of employee stock plans around ESOPs are the most common form of employee incentivisation for small and start-up businesses.

In our experience, an ESOP often represents the best way to incentivise an employee’s performance, whilst still allowing the company to maintain the control it desires and not tying it down with admin.

So what are the benefits of an ESOP?

• Incentivise – We have all been in that situation where as an employee, you feel like you are working your hands to the bones, and the usual discretionary ‘bonus structure’ just doesn’t cut it anymore. ESOPs allow employees the opportunity to become part of the Company. This means they have intrinsic motivation to see the company become profitable, rather than solely focusing on their own pay cheques week to week – they are in it for the greater good of the Company.
• Retention – Most ESOPs contain ‘time based vesting’ conditions, which encourage the employees to stay at the Company. This means that the options cannot be exercised (converted into ordinary stocks in the company), until they ‘vest’. And for an option to vest, the employee will have to remain employed or engaged by the Company for certain periods of time. The most common terms we see involve 25% of an employee’s options vesting after 12 months of employment, and then the remaining 75% vesting on a monthly basis over the 3 year period commencing on the after the first anniversary.
• Recruiting – As a start-up, you may not be able to match the corporate salaries that highly talented and experienced candidates may receive in their corporate jobs. However, by offering equity in the business, you can compromise. Many start-ups are able to attract talent by offering them a combination of salary and equity, in order to close the gap and get the best talent on board.
• Tax – Many jurisdictions around the world have made changes allowing for ESOPs to be more tax effective for both the employer and the employee, with various concessions and methods of calculation available. With these concessions, an employee is able to be incentivised without attracting further tax liabilities.
• Customisation – ESOPs can be drafted to suit your companies needs. The vesting conditions can be different for each employee (for example, some employees may need to meet certain KPIs, and other employees may only need to meet the time based vesting requirements). This way, you are able to structure the ESOP so that it provides the most value for your company, while incentivising the employees to the greatest extent possible.

Common worries

So if ESOPs are so worthwhile, why doesn’t every company have one?

We have set out below the most common concerns we hear in relation to ESOPs, and in general, most are fueled by simple misunderstandings.

“What if an employee leaves – I don’t want ex-employees leaving with equity in my Company”

Most ESOPs contain general ‘buy-back’ provisions, which allow the Company to buy options and stocks back from employees in certain circumstances. One of those circumstances is when the employee leaves. ESOPs will specify the price that will be paid for those stocks, often based on whether the employee was a ‘Good Leaver’ or a ‘Bad Leaver’. As mentioned above, these terms can be completely personalised for the Company, to cover any hypothetical scenario it may have in mind.

“How do I know the value of the options? I don’t want to give too much away?”

Cake can help you to get valuations for your company to be used in your ESOP.

It can also assist with providing a valuation to put a dollar value to each option. This will be helpful when using options as a substitute for a salary. For example, rather than paying an employee a $100k salary, you could offer a $75k salary, in addition to $25k worth of options, that will vest over 3 years of employment at the Company. More cash left in your pocket, and more incentivisation for the employee.

“How could I ever keep track of when employees are meant to be granted stocks? And how would I find time to do it?”

Cake can solve this issue for you. Once you’ve created your ESOP on Cake, it will automatically track time based vesting rules.

This way, once an employee’s options have vested (and can therefore be exercised to be issued stocks in the Company), both the employee and the Company will get a notification. From here, they simply click a few buttons and the stock issue is complete.

We have created the platform on a ‘set and forget’ basis, allowing you to focus on the growth of your Company, while the options incentivise in the background.

As part of your ESOP package, you will also get access to a simple dashboard for the Company to keep track of how many options have been issued, how many have vested, and how many are left to grant to future employees. Each employee will be provided an account where they can keep track of their options, without seeing any other confidential information of the Company.

ESOPs seem like a no brainer – Why doesn’t every start-up have one?

Start-ups will often talk about offering stocks to early stage employees, and they will maybe even promise it, but often, they don’t make it happen. Why not? They think it is too complicated, too expensive and too time consuming.

Well, that was true. But now, Cake can help.

Cake offers template designed ESOPs, which can be individually altered to suit your specific needs – in minutes. Cake can assist in getting basic valuations, the sending of offers, electronic executions, and setting up automatic vesting rules in the platform. It’s all about setting and forgetting, and watching the benefits roll in. Book a demo today to see it all in action.

Cake makes equity easy.

If you liked this article, check out Early Bird Gets the Worm – 5 Reasons to Set Up Your ESOP Now

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.