Demystifying ESOPs for Early Stage Founders

Written By:

QAPITA Team

March 15, 2022

Introduction

Being a startup has its challenges. Having a great idea is not enough. In fact, just ideas seldom get funded. You need to back it up with a formidable team that can execute the idea. To attract the industry’s best talent, startups have to offer huge sums of money as salaries. But how often can they afford to offer such salaries in the early stage? Startup founders need to conserve cash to invest in the business in its initial stages. Wages are a monthly expense and create an impact on their cash pool. Keeping a low fixed cost is a recommended approach, but so is building a strong team. Can startups then afford to compromise on the quality of talent?

Angel investors and Venture Capital (VC) firms put a lot of their focus in assessing the following before they show an intent to invest.

How invested are the startup’s team members in the vision of the founder?
What are the competencies, skills, and achievements of the team members?
How and where are the founders spending their cash pool?

A catch-22 situation, thus, for early-stage founders is that they need to hire the best talent to attract funding, but they lack funds to bring them on board.

ESOP: A Silver Bullet

The initial years of the startup are volatile, and employee retention becomes difficult with each day. Employee stock option plans, also known as ESOPs, are becoming the favoured choice of early-stage founders. Through ESOPs, startups offer their employees the right to acquire shares. These rights are also referred to as stock options. Startups bundle these stock options with a lower fixed salary thus giving an opportunity for key employees to unlock value as the startup does well, thus aligning the incentives of the employee with the company. The following reasons are driving the popularity of ESOP as an option to reward employees:

ESOP helps to acquire the best talent in the market.
ESOP helps in preserving the cash pool for investment in the initial stage.
ESOP removes the need to immediately dilute the ownership for meeting salary expenses.
It brings in higher commitment among employees and aids employee retention.

ESOP: How Does it Work?

ESOP is a right-for-stock option that is offered to an employee. Startups would have to document the terms and conditions related to the price, the lock-in period, the vesting date, and the exercise date. The following paragraphs refer to some of the terms associated with ESOP.

For example, at the time of hiring, a startup offered 10,000 options on the 31st of March 2020. The terms and conditions stated that the employee could vest 20% of these options after the 1st year, 40% at the end of the 2nd year, and the remaining 40% by the completion of the 3rd year at Rs X. It means the following for the employee:

The employee has the right to purchase 2000 shares on the 1st of April 2021, 4000 shares on the 1st of April 2022, and the remaining 4000 on the 1st of April 2023.
The date on which the employee becomes eligible to purchase the shares is called the vesting date
The process by which they earn the right to purchase a particular number of shares is called vesting.
The actual process of purchasing the shares is termed Exercise as the employee exercises their option to purchase the shares
The date of exercise is the Exercise Date and the price at which the employee has the right to purchase shares is called the Exercise Price.
The Lock-in period for vesting is one year, or in other words, the plan has a one year cliff.

Cliff is the time after which the employee can exercise the first portion of the option. In this case, it is on the 1st of April 2021 and involves 2000 shares. There is no compulsion for the employee to exercise, as the decision to exercise the right rests with them.

In case the employee leaves the organisation without exercising their rights, the unvested shares typically go back into the ESOP pool. Exercise Price can vary based on the startup’s policy and is stated in the grant letter. The company can offer these stocks for free, at face value, or the company’s market valuation. Usually, startups offer them at face value or a price that is typically lower than the market value. The above example is of time-based vesting. Startups can also design plans with milestone vesting or hybrid vesting. Milestone vesting plans offer a vesting period linked to milestone achievements like turnover, etc. The hybrid plan includes a time period and milestones.

ESOP is not designed as a one-size-fits-all. A good ESOP plan is in line with the short- and long-term goals of the organisation. It requires a deep understanding of the ecosystem, rules related to taxation, transfer of shares, CAP tables, and company laws. By being on Qapita’s intelligent platform, startups can digitally manage their stock options and cap tables effortlessly.

To summarize, ESOPs are effective only when designed and communicated well. Any failure on this part leaves employees unclear on the benefits and hampers ESOP as a tool for startups.