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In the ongoing battle for top-tier talent, startup businesses often struggle to match the pay of larger competitors. This is because, to scale quickly, startups often need to minimise expenses and reinvest earnings back into the business. Consequently, your business may not be able to offer as much in the way of cash salaries and bonuses. Therefore, employee share option plans (ESOP) make fantastic alternatives to cash remuneration. This article will look at how you can make an ESOP offer.
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Creating the ESOP Scheme
An ESOP scheme records the particulars of the ESOP arrangement. Outside of certain tax and legal limitations, businesses have wide discretion in implementing ESOP schemes.
We will now consider the following key aspects of an ESOP Scheme.
Employee Eligibility
You may only want certain employees to participate in the ESOP. Alternatively, you could open it to all employees that joined before a particular date or keep it open-ended. What you choose depends on your business’ circumstances, recruitment strategy, and future fundraising goals.
Vesting Conditions
Vesting refers to the point at which the share options convert to actual shares in your business. At this point, eligible employees will have ownership rights in your business.
Again, you have broad discretion to determine these conditions. Nevertheless, a common vesting condition is the first of either:
- securing a specified fundraising event (such as a series funding or initial public offering); or
- a specified anniversary after employees become eligible to join the ESOP.
Vesting conditions are important because your business has a legal obligation to honour them when they are fulfilled. While you can specify that your business has absolute discretion when determining vesting conditions, this will make the ESOP less competitive. Therefore, your business may benefit from clearly stated and reasonable vesting conditions.
Rights Attached to Shares
For all shares, shares usually govern the following three rights in the business:
| Rights to dividends | A right to a dividend means that the shareholders receive a share of dividends based on the number of shares they own. |
| Rights to capital | This relates to when the business is wound up under some business sales or insolvency. Shares with rights to capital entitle the shareholder to share in the remaining assets after all creditors have been repaid. |
| Rights to vote | These entitle shareholders to the right to vote at general shareholder meetings. |
Most businesses with ESOPs create a new class of shares specifically for employees. For instance, founder shares may have voting rights, rights to dividends, and rights to capital attached to their shares. But for ESOP shares, you may wish to remove voting rights.
As with vesting conditions, the better the rights attached to the shares, the more attractive the ESOP is from a recruitment perspective.
Employee Exits
Nearly all ESOPs terminate an employee’s vesting rights if they leave the company before the shares vest. However, the situation is more complicated if an employee’s shares have vested and then they leave.
Private companies typically restrict the ability of any shareholder to transfer their shares to unaffiliated third parties. At the same time, you typically cannot simply force an employee to hand over shares after they vest. For these reasons, you may have a term that obligates employees to sell their shares back to the business at a pre-fixed price.
Calculating the Options Pool
The options pool refers to the total number of options which, upon vesting, will become shares. From a share capital perspective, this is a reserve of the total share capital in existence. The size of the options pool can dramatically impact the valuation of your business and how much future investors are willing to invest in future fundraising rounds.
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Calculating the Exercise Price
While some businesses are happy for shares to vest in exchange for a nominal price (often fractions of a pence), other businesses may require employees to pay closer to the market price to exercise their share options.
Where the exercise price is more than the nominal value of the shares, you will need to obtain a proper valuation of your business to determine the price.
Legal Formalities
ESOP schemes are complex legal arrangements between your business and employees. It also impacts existing shareholders’ rights and can influence your business’s value. Therefore, you may wish to instruct solicitors to help you implement the scheme. They will help you draft the ESOP scheme agreement and make the appropriate amendments to your company’s articles of association.
You may also wish to consult with an accountant to ensure the ESOP does not create any undue tax burdens or negatively impact your business valuation.
Key Takeaways
ESOP schemes are a great way to attract talent, especially if your business is a startup. However, they are complex legal arrangements that require careful drafting and execution. After all, your business is bound by the terms, and you can inadvertently entitle employees to more rights in your business than you intend. Therefore, seeking legal advice before implementing an ESOP offer is essential.
If you need help with your startup, our experienced business lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
An employee share options plan, or ESOP, entitles your employees to participate in your business’ success. Provided the terms and conditions of the ESOP are met, eligible employees obtain shares in your business.
Typically, the ESOP will dictate which employees are eligible to participate in the scheme, the conditions under which employees become entitled to their shares (called vesting), the rights attached to the vested shares, and what happens to the ESOP shares upon an employee’s exit from the business.
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