Making Employee Share Options Work
Updated: Jul 8, 2020
How do you make employee share options work? By that I mean, how do you ensure that they serve their dual purpose of incentivising and retaining talent? Too often, discussion around ESOPs are held in a bubble world composed of founders and investors, and the perspectives of employees, if not entirely forgotten, come a distant third. Those discussions, and the resulting plans, tend to focus a great deal on retaining talent, but rather less on ensuring the effective incentivisation of employees. Here are a couple of things to bear in mind if you are looking to structure an effective ESOP.
ESOP as part of global remuneration
Founders frequently think of ESOP awards as something additional to, and separate from, the remuneration package of employees (base salary, benefits and bonuses etc.), when in actual fact they need to be looked at as an integral part of employees' remuneration. This is important not only because of the (potential) value that ESOP awards represent, but also because different employees will value ESOP awards very differently.
The potential value of ESOP allocations
Founders need to be clear with employees as to the value that their ESOP awards represent. At its most basic level, this is the present value of the awards, being the difference between the strike price of the awards (fair market value or less, depending on jurisdiction) and the last price at which the company raised equity financing. More widely construed, it is the potential value that the company is expecting to generate (based on its business plan forecasts and budgets) in the coming years culminating in the holy grail of a trade sale or IPO, less the strike price. None of these values are, of course, guaranteed, but that doesn't make them unimportant. After all, if you don't see the value in the ESOP awards, how can you expect your employees to?
The cash vs ESOP trade-off
Once you are clear on the value of ESOP awards, it is important to use that information in discussing remuneration packages with current team members and future hires alike. Remember that you have two budgets to play with: a cash budget and an ESOP budget.
Take an example of a new tech hire from Googlefacebookapple, who is earning $200K. You can't match that salary, but you should have at least two types of offers up your sleeve: one that is cash-heavier and one that is ESOP-heavier. For example: $120K in cash and $80-100K (based on last round price or expected next round price) in ESOP awards OR $140K in cash and $40-60K in ESOP awards. Those who take more ESOP will get a remuneration bump (or at least not a cut) while those preferring cash will stay level (or take a modest cut).
Is the one who wants more ESOP (and is willing to take less cash) a bigger believer in the company? Possibly, but the decision by an employee here is much more likely to be rooted in the personal financial position of the employee than anything to do with their view of the company's prospects. The key, as in all things employee-related, is to understand each individual employee's motivation and therefore to try to give them the remuneration package that is right for them (within the limits of your cash and ESOP budgets). A one-size fits all approach ignores the fact that not all (to take a random example) mid-level tech hires would choose the same.
An affordable and available plan
Although there are many different types of ESOP and many more detailed terms that can be tweaked this way or that (vesting schedule, acceleration etc.), unless the ESOP is both affordable and available to employees, it will likely fail to meet its objectives.
It is critical that employees are able to conceive of a way in which they can afford to exercise their options; that is, the ESOP needs to be affordable. There are two potential components to affordability: the strike price and any tax liability.
For many start-ups, setting the strike price is a relatively straight forward matter of ascertaining the fair market value or "FMV" of the options whether based on an independent valuation report (US 409A valuations) and/or agreed with the tax authorities (UK EMI options). By setting the strike price at FMV, you can ensure that employees in jurisdictions such as the UK and US can avoid a dry tax liability on exercise and it seems a reasonable trade-off to ask employees to pay the FMV strike price to avoid that kind of tax liability. This, however, should not detract from the general proposition that it should be in everyone's interest to keep the strike price as low as possible (whilst adhering to the FMV rules) in order to give employees maximum upside potential.
In much of Europe, however, there are no such favourable tax regimes and if employees are given options under a traditional UK or US scheme, they would be hit with the double-whammy of having to pay tax and the strike price (even if set at FMV) on exercise. One partial solution is to have a strike price of zero (or as close to zero as possible). However, the tax liability remains and that is something that will need to be satisfied in cash.
So how can you ensure that your ESOP is sufficiently affordable?
In countries where the strike price is set at FMV to avoid a tax liability, affordability can be enhanced relatively simply by allowing options to be exercised on a cash-less (or "net exercise") basis. In other countries, where a dry tax liability does arise on exercise (even if the strike price is FMV as at the grant date), it is important to think through how you make option exercise affordable. One solution is to make the plan an "exit only plan" or a "virtual share plan" where the options can be exercised or cash bonuses are paid only on an exit (i.e. when the employees are hopefully receiving proceeds well in excess of the exercise price and any tax liability). This won't appeal to those employees who hope to sell their shares (after option exercise) prior to exit in a secondary transaction or who ascribe value to being a fully-fledged shareholder in the company. And what happens to an employee who leaves before an exit? A better option might therefore be to build in greater flexibility as to when options can be exercised than is typically found in UK and US plans. That is, to increase the plan's availability.
Traditionally, options lapse 10 years from the initial grant date and, if an employee leaves the company before then, there will usually be a relatively short period of time (60 to 90 days) in which they may exercise their vested options. If not exercised during that period, the options are forfeited. While this is standard, it doesn't mean that it always (or ever) makes sense. This type of rule has the effect of prioritising retention over incentivising performance and, while a company needs all of its employees to be hungry and motivated, how many founders expect all of their employees at Seed or Series A stage to still be with the company at exit?
What seems likely is that an employee will not feel as incentivised as they should when they know that leaving the company (probably due to entirely reasonable personal or professional reasons) means having to exercise their options and that exercising their options means spending money (as payment of strike price and/or to satisfy a dry tax liability) that they don't have.
A credible alternative is to allow leaving employees to keep their vested options until, for example, the earlier of expiry or an exit. This make leaving somewhat less painful (and theoretically, at least, may lessen retention) but will increase the likelihood of exercise being possible (or possible in greater amounts) and at a time when the company is soaring. And surely that prospect is what makes share options work.