ESOP 101: What to know before you start

1. Why ESOP

Many fast-growing companies across the world are now adopting employee stock ownership plans. ESOPs let founders divide a piece of the company pie among employees, contractors and advisors. ESOPs can take on many shapes but their identical goal is to enable their participants to benefit from the company’s growth.

ESOP benefits both sides of the equation. It helps founders attract top talent even when the company’s strapped for cash while also promoting healthy company culture. In return, the team gets a unique chance to invest in a company they know and understand.

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2. Who should implement ESOP?

ESOPs can be a great option for a wide range of companies but they may not be suitable for everyone. In general, ESOPs work best for companies that meet the following criteria:

1. Expected year-to-year growth is above 20 %: ESOP is a powerful tool for employee motivation and the key driver is seeing how the company’s valuation grows because the value of employees’ portfolio grows with it. But if the company doesn’t expect to grow, the employees will not see a substantial increase in their shares’ value and the ESOP will not work to its full potential.
2. Company is not profitable yet: Once a company is profitable, it can simply distribute the profit to the team. ESOP works best for non-profitable companies because instead of dividends, it promises a substantial payout once the company scales.
3. Company wants to attract and retain talent: ESOP is primarily a hiring and retention tool, so it works best for companies that have a strong need to either hire or retain talent.
4. Founders want to promote an ownership mindset: With an ESOP, you are essentially redistributing a part of the company to your team. This is a big step for any founder and it’s important to have a set mindset that this is the right thing to do.

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Here are some examples of companies that successfully implemented ESOP:

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• The Czech unicorn Productboard launched ESOP for their full-time employees to incentivize loyalty. They believe that democratizing the fruits of hard work aligns motivations and encourages teamwork, making stock options integral to their continued growth.

• Booking.com implemented ESOP to incentivize long-term growth and attract top talent. The program allowed all employees who had been with the company for at least one year to participate with a maximum investment amount of €10,000 per year.

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While ESOPs can be a powerful tool for many companies, they may not be suitable for everyone. Launching ESOP can require complex implementation and a lot of ongoing administrative and legal compliance. Make sure to select the right partner that will streamline the process for you. Find out how our Eldison platform can help you.

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3. When is a good time to implement ESOP?

The implementation can be done at any stage of a company's lifecycle but the biggest differentiator is the company’s motivation and needs. In general, the sooner you have it, the sooner you can enjoy its benefits. Here is how both startups and scaleups can benefit from launching an ESOP:

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Startups

ESOP can help attract talented team members who may be willing to take a lower salary in exchange for equity. Hiring top talent at an early stage is crucial for the company’s future because a skilled and motivated team is crucial to the company’s success. Plus, investors always look at the team in early-stage rounds as they are the core of the business at that moment.

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Scaleups‍

Once a company scales, the key focus goes to employee retention and creating a healthy company culture. Having an ESOP in place creates a company culture based on ownership and provides a way to incentivize employees to help the company achieve its long-term growth objectives.

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4. How to implement ESOP?

Implementing an ESOP can get complicated, especially for first-time adopters. Streamline the process with a clear agenda including the following steps:‍

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1. Select your partner

You’ll need somebody (typically a lawyer) to help you pick the right ESOP and implement it. Then, you’ll need to take care of ESOP management. That involves issuing new awards, updating company valuation, managing newcomers and leavers and more.

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The good news is that there are many tools that can help you automate this process. If you are looking for a solution that covers all areas, from plan selection and ESOP management to employee communication, visit our product page to learn more about our end-to-end ESOP platform.‍

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2. Choose your plan

Before getting started, you’ll need to decide which ESOP plan you’ll adopt. This depends on multiple factors like the location of your corporate headquarters, tax sensitivity and the budget allocated to ESOP implementation and management.

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In general, there are four types of plans that can be used: phantom shares, direct shares, stock options and trust-based benefits. Each plan has its pros and cons. If your company is looking for a tax-efficient solution, you may be able to benefit from tax-friendly jurisdictions like the UK (EMI stock option scheme), the US (US stock options) or the Netherlands (through the-so called STAK foundation), depending on the location of your corporate headquarters and your team.

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3. Create and divide your ESOP pool

Now, you need to slice up your ESOP pool and decide how much you’ll allocate to your team. At seed, ESOPs are traditionally set at 10 % in both the US and Europe. US startups then typically increase their pool to 15 % at Series A up to 20-25 % at Series D. In Europe, the ESOP pool often stays at 10 % throughout the funding journey, but we see the trend changing here as well.

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Once you decide on your ESOP pool size, it’s time to allocate it. Make sure you take into consideration future hires as well as current employees.

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4. Decide on key ESOP parameters

Next, you should establish the rules of your ESOP. There are many parameters to go through. We’re listing a couple of those that are absolutely crucial for getting your ESOP off the ground:

• Vesting parameters: Vesting period, cliff and vesting schedule. Together, these will decide when your employees get the full benefit of their grant. The current market standard works with a 4-years vesting period and a 1-year cliff. Vesting typically increases on a monthly basis.
• Standalone vs. swap awards: If your ESOP works with standalone awards, you give company shares on top of the regular salary and bonuses. Swap awards let your employees “swap” a part of their salary increase or cash bonus for equity.
• Good Leaver & Bad Leaver scenarios: You need to decide what happens when somebody leaves your company as a Good Leaver (without breaching their obligations to the company) or Bad Leaver (while breaching a crucial obligation to the company). Bad Leavers typically lose their ESOP rights or are otherwise penalized.

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5. Create legal documents

Before you can launch your ESOP, you need to make sure that you have your documents ready for every process. You’ll typically need ESOP Terms, an Award Letter to be signed by each participant and any other documents needed to manage the plan (e.g. termination or buy-back documentation).

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6. Introduce ESOP to your team

ESOP is a benefit for your team, so it's important to communicate it early and often. This includes explaining the benefits of ESOP, the process of how it works, and what are the rules set up for the program. It’s also great to provide regular updates on the company’s growth to keep your team motivated and both sides get the most out of this program. Instead of sharing numbers in an all-company meeting, consider using our platform to show your employees how their portfolio evolves over time. Learn more here.

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7. Start awarding

If you followed all the steps until here, you should be ready to launch your ESOP with ease! And if this seems like too much, you can always schedule a call with us to get more information.

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Conclusion

• ESOP is a valuable tool for hiring top talent and retaining and engaging your current team.
• There are four key factors that go into deciding when to implement ESOP. Your company should be expected to grow at least 20 % year-on-year, it shouldn’t be profitable yet, your goal should be to hire and retain talent and you should genuinely wish to promote an ownership mindset within your team.
• Timing is key. The decision to implement ESOP should be based on the company's lifecycle stage and pressing needs. But the sooner ESOP is implemented, the greater benefits it can offer.
• The implementation itself can get very complicated if you don’t have the right tools in your hands. We recommend finding a trusted partner who will take the burden off your shoulders from start to finish.

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Eldison has its own end-to-end ESOP platform that simplifies the management of employee equity from start to finish. If you are interested, continue reading here.