ESOPs (Employee stock option plans) are a common mechanism for incentivizing the best employees and top management. It originated from startups, where company equity is often the most affordable type of compensation.
Startup founders use ESOPs in various legal and financial forms to retain the best talents and reduce the company’s annual burn rate.
Sometimes the in-house legal counsels get to know about new ESOPs offered when the terms are already negotiated. And sometimes, those new ESOPs don’t fit anywhere – neither in the corporate structure nor in the cap table due to shareholders’ rights limitation.
Here are the 4 reasons you should tell your lawyer before offering ESOPs to someone:
ESOPs should be planned ahead
ESOPs may be offered chaotically when the team is recruited at a very early pre-seed stage. Zero judgment to founders who need to invite and retain the best talents in the core team – CTO, CPO, software engineers, or marketing director.
When the startup is about to attract its first investments, the first internal due diligence is typically performed (if the lawyer was not hired earlier). What I see quite often is that the total percentage of ESOPs exceeds the standard ESOP pool % which is between 7% to 15%, the golden standard is 10%.
This is not a problem when the first funds were bootstrapped for the company. However, the investors do not see the business as “safe” for investments when 30% of equity belongs to the employees (not solely to the founder). The company valuation can also be compromised in this case as it’s quite tricky to substantiate that the employee-owned equity is worth the same as equity issued for investors in a seven-figure investment.
Thus, when offering the ESOPs to the core team at an early stage, think in advance about the option pool size. How much equity total you are ready to allocate for the employees? Would it be 10%, 15%, or 20%, it should be the final number. Then distribute shares accordingly among the team, always reserving some % for future hires because you never know.
Investors want fully diluted equity
I have created a separate article on Medium about this and how the dilution works with examples. Check it out.
ESOPs might interfere with shareholders' rights
As a founder, you always need to approve all share capital increases with existing shareholders.
Of course, the main reason for this is that they don’t want to be diluted. However, in most cases, the founders themselves would not have a legal right under the company Articles of Association to issue new shares out of the blue. And ESOPs are always = new shares, right now or in terms of time, it doesn’t matter.
ESOPs trigger a change in the share capital and it’s always a reserved matter for the Shareholders’ special majority vote (75%) or should be confirmed by the Board of Directors (depending on how you organized the corporate governance rules).
Of course, in many startups, the right to increase the share capital can be initiated with a simple majority (50% + 1 share). But in my personal opinion, this scenario might be dangerous for the founder who usually ends up with less than 50% of equity after the investment rounds.
The number of shareholders increases, equity becomes very fragmented (one shareholder has 12%, the other one – 17,5%, third – 22%), and the founder remains with a percentage below the level to make decisions about share capital increase in the company.
With a special majority, your vote will be required to issue shares always, until you have 25% or less. This is usually the case in later stages when the Board of Directors makes the most strategic decisions and the founder is not expected to do everything by themselves.
Therefore, be cautious when you can decide on ESOPs by yourself and when you need approval from the existing shareholders.
The ESOP % might not be at the market rate
The first-time founders might feel confused when negotiating the ESOPs with the core team. What is the right percentage to offer and don’t leave anyone feeling underestimated?
There is no such thing as a “market rate” for defining ESOPs %. However, there is enough industry experience to rely on and build a relatively working framework for incentivizing the team taking into account investors’ interests.
I had a case when the founder was hiring key team members and was asked for the 25% ESOP. For one employee with project management and strategic planning responsibilities. Of course, this can be the exception to all rules if this employee will multiply revenue 3 times from what it is now and attract new investments. But you cannot know this in advance, only post-factum.
The golden rule is to start from 1% for the top performers and people you want to keep by yourself if not forever then at least to the upcoming exit (this is what everyone wants, right?). And if you see the progress you can always increase the equity for this employee.
However, if you start from the bigger percentage and later come to the conclusion that there is no room for more ESOPs for other team members or even there is less to offer to the investors without directly cutting your own stake, there is no way back. You will not be able to reduce someone’s high ESOP stake just due to the business need. It does not work this way.
Of course, there is always a possibility to issue new shares and artificially dilute everyone. But in this scenario, you will dilute yourself as well.
_So be like that founder I mentioned, tell your lawyer first before promising ESOPs to anyone.
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Author – Yuliia Verhun, IT Lawyer
All intellectual property rights to this Article belong to Yuliia Verhun.
