The history of companies, especially those that have changed the world, is full of stories of employees who became millionaires thanks to shareholdings in the company. An example is Microsoft, which generated approximately 12,000 millionaires in its first ten years. How did they achieve this success? It’s simple, they used employee stock option plans (“ESOPs”).
In Part 1 of our series on employee stock option plans, we introduced and immersed you in the world of ESOP, covering the basic principles and mechanisms of these plans.
In today’s blog, we will focus on the basic key concepts you need to know to understand how ESOP plans work. These concepts will then become an integral part of your life with ESOP plans in your startup, especially when implementing these schemes if you are a founder, or when negotiating them if you are an employee.
Basic key concepts
To better understand how ESOP works, it is important to become familiar with some of the key concepts associated with ESOPs. When negotiating the terms and conditions of your ESOP, in many cases (especially in the early stages of a startup’s life when implementing ESOP terms) you may encounter a document called a Term Sheet. It contains the basic business settings of the ESOP. It is in this document that you will first encounter key concepts that will accompany you throughout the existence of the ESOP plan.
Equity ESOP – a type of ESOP plan under which the ESOP participant acquires options (i.e., the right) to purchase shares (a certain % of shares – Grant Size) in a company at an agreed-upon price (Strike Price), subject to certain conditions for Vesting. The ESOP participant thus acquires an equity interest in the company and becomes a member/shareholder of the company (with all the associated rights) upon purchase of the shares.
Virtual ESOP – a type of ESOP plan under which the ESOP participant acquires a virtual share or virtual shares (Phantom Share) in the company. Virtual shares carry various rights as described in the ESOP plan, and are typically associated with the payment of a certain amount of money (bonus) to the ESOP participant in the event of an Exit Event (see below).
Option Grant – a process where an employee enters an ESOP plan and is promised that if certain conditions are met, he or she will receive a (virtual) share of a certain amount or a certain number of shares (Grant Size).
Employee Equity Pool (or ESOP Pool) – the total amount of (virtual) shares in the company to be distributed to ESOP participants under the ESOP plan. This indicator is important to give each participant an idea of the size of their virtual share in relation to the other participants. The standard in the Czech and Slovak markets is that a (virtual) share of 5 to 10 percent is distributed in this way.
The ESOP Pool is particularly important for founders and investors. It gives them an overview of how much will be “carved” from the proceeds of the sale of the company (or from another liquidation event, see below).
Strike Price / Base Value – the purchase price at which the ESOP participant receives a (virtual) share (shares) in the company. In the case of an equity ESOP, the Strike Price has mainly tax and psychological implications. If the participant has to pay some money for the share, then they are psychologically more motivated and interested in the success of the whole project, because they too have invested some value. We will address tax issues in the next part.
Vesting – the process of activating the entitlement to a share / bonus component. Vesting can include two criteria: the time criterion – Vesting Period (explained below) or the performance criterion – Key Performance Indicators (KPIs). KPIs may be associated with various performance goals that vary depending on the work the ESOP participant performs for the company. This can be, for example, the number of hours worked, turnover criteria, etc.
Vesting Period – the period of time during which the entitlement to the shares / bonus component is activated. The typical time frame is 2 to 4 years. This is meant to motivate the participant to work for the company for a longer period of time in order to “deserve” the entitlement.
The basic rule for each Vesting Period is the mandatory performance of work for the company for the entire duration of the Vesting Period – for example, in the case of an employee, to remain employed for the entire Vesting Period. If participation is terminated prior to the end of the Vesting Period, the participant will not be entitled to the share or the bonus component. However, this rule is not universal; for example, if a participant terminates their participation as Good Leaver (see below), they may be entitled to a portion of the bonus component or shares.
The Vesting Period must be set with utmost care for each participant. The longer the period, the less motivated the participant. The same is true for a period that is too short (e.g. 1 year), where the participant has less incentive to work because they know that the benefit of the ESOP plan will be received after a short period of time.
Reverse Vesting – the time required to retain the right to hold the shares. You will typically encounter this tool in a direct equity ESOP, i.e., where the participant (usually the most key individuals) receives shares in the company immediately. The company or the other founders then have an option vis-à-vis such participant, the size of which decreases over time. It is thus the opposite of Vesting (which we see in virtual ESOPs), where the ESOP participant gradually acquires the entitlement to the option share (shares), or their option share (shares) gradually increases. In the case of Reverse Vesting, the ESOP participant fully owns the option share (shares) from the outset. However, the Company has the right to redeem the option share (shares), in whole or in part, from the ESOP participant during the Reverse Vesting period.
Cliff period – this is a “trial” period during which actual Vesting does not occur. It is usually for a period of 1 year. Should the participant’s participation be terminated for any reason during this one-year period, the participant will not be entitled to any (virtual) share. Once this milestone is passed, the Vesting period is automatically accounted for retroactively (i.e. the participant will not lose this year).
Grant Size – the size of the share (shares) offered to a particular ESOP participant. If the Vesting conditions also include KPIs, a maximum Grant Size can be set which the participant will receive if they meet all Vesting conditions.
Exercise – the exercise of an option or bonus component. This is the right of the participant to exercise the option or bonus component. Most often it is set to trigger automatically upon an Exit Event (see below). However, in order for the exercise to take place, the Vesting conditions (see above) must also be met.
Exit (Liquidation) Events – events on which the exercise of the option is conditional (or which activate the right to payment of the bonus – i.e. Exercise). These are events that may affect the value of shares held by ESOP participants and the ability to sell or redeem them. Liquidation events can also serve as an incentive for employees who see the potential for future financial reward if the company reaches one of these milestones.
Examples of liquidation events include:
- Sale of the company or a significant part of its assets: The company or its substantial part is sold to a third party or an investor, or the company sells part of its business or assets. This may mean the opportunity for ESOP participants to redeem their shares or exercise the bonus component.
- Restructuring of the company: The company merges with another company or spins off part of its assets.
- Initial Public Offering of shares (IPO): The company publicly offers its shares, which may allow ESOP participants to sell shares to the public.
- Dissolution or liquidation of the company: The company is wound up and goes into liquidation.
- Payment of dividend: Some ESOP plans may treat the payment of a dividend as an exit event because it may affect the value of the company.
- Changing the company’s structure: For example, a reorganisation that leads to a significant change in ownership.
Payout – payment of a bonus to the ESOP participant (in an amount proportionate to their option shares) upon Exit.
Good Leaver / Bad Leaver – circumstances that have an impact on the exercise of the option or the amount of the bonus component.
An ESOP participant is said to be a “Good Leaver” if they leave the company for reasons beyond their control or that are considered acceptable. For example:
- Health reasons or disability (e.g. for more than 3 months);
- Responsible exit, e.g. due to reorganisation or retrenchment.
In the case of an equity ESOP, the participant often has the right to redeem the shares (if the option has already been exercised) or to exercise their stock options, subject to the terms and conditions set forth in the ESOP plan, or, in lieu of receiving the shares, the participant receives an equivalent value in cash.
In the case of the bonus component (i.e., a non-equity ESOP), the participant is generally entitled to receive payment of the bonus component, either in full or in part, depending on the length of time they have worked for the company (or other criteria where applicable).
A “Bad Leaver” is a participant who terminates their engagement with the company for reasons that are considered unacceptable. For example:
- Termination notice for violation of the law (e.g. employment regulations, criminal offence);
- Optional departure without a notice period;
- Other reasons that the ESOP plan may define as “bad”.
If a Bad Leaver, in equity ESOPs, the participant may lose all of their shares or may have to sell their shares back to the company at a predetermined price (often below market value). The bonus component is usually forfeited. Hence, the participant will not receive the bonus or its part to which they would otherwise be entitled.
The above definitions provide the key to understanding how ESOPs work, and every founder who is considering implementing an ESOP in their company should be familiar with them.
In our next blog, we will address virtual ESOPs.