ESOP, option share, virtual share or share option plan - have you heard these or similar terms in the start-up world? These terms probably sound familiar to any founder, employee or investor, but do we really know what lies beneath them? Is it a shareholding in a company, a share in the profits, or perhaps an employee's possibility of receiving a bonus, and are these plans for employees only? All of these questions and more will be answered in our multi-part series on employee stock ownership (option) plans ("ESOPs").
In today's first post, we will focus on the general concepts of ESOPs and their importance for start-ups and their employees or associates.
What is an ESOP?
ESOP is an abbreviation for Employee Stock Ownership (Option) Plan, which means "zaměstnanecký akciový (opční) plán" in Czech. It is a program that allows employees (or other associates) to become involved in the running of the company as partners (shareholders), to share in the success and growth of the company's value, and to be a bigger part of the overall project.
ESOPs are distinguished primarily according to whether the employee will have the right to acquire an equity participation (an ownership interest or shares) in the company or "only" a financial reward/revenue as equivalent to his or her virtual share in the company. In the Czech Republic, start-ups can offer their employees four basic forms of ESOPs, which can be partially combined:
- Virtual / Phantom ESOP
- Equity ESOP
- Direct sale of ownership interests or shares
- Employee company
In the Czech environment, however, we most often encounter a virtual ESOP, whereby the employee acquires a virtual share in the company. If certain conditions are met, the employee is then entitled to a wage bonus. We'll talk more about all forms of ESOPs in the next post.
What type of company is an ESOP suitable for?
ESOPs are important and beneficial for all stages of a company's development. Whether it's the establishment and growth stage, the expansion stage, or the maturity stage of a company, it's always key to retain talented employees, attract new talents, and keep up with rapid growth.
ESOPs are particularly important for companies that plan to grow at around 20% per year, so that such growth is sustainable for the company in terms of its key employees and cash flow. Of course, as companies grow, the pressure to raise employee wages and remuneration increases, which can have a fatal impact on fast-growing companies. Not only can key employees and know-how holders leave, but companies will not be able to attract additional talented employees, which can lead to stagnant growth.
Why want an ESOP in the company?
Start-ups and fast-growing companies often face challenges in recruiting and retaining talented employees, especially in today's highly competitive IT and technology job market. Start-ups are often struggling with limited resources and are thus unable to retain talented employees or offer them comparable conditions to those offered by larger corporations. It is therefore necessary for start-ups to find an effective tool to attract and retain these talented employees.
At the same time, the vast majority of start-ups are technology companies whose greatest value is copyright in all its forms, especially source codes, new technologies or innovations, which are held by key employees or co-founders If the company cannot retain such a copyright holder and does not have such copyright secured by other legal means, such copyright holder's leaving may well spell the end of the start-up. It is therefore necessary to retain such holders of important know-how and IP in the company.
ESOPs therefore offer a number of benefits that can help overcome the above challenges. An ESOP provides start-ups and employees with the following business and factual benefits:
1. Employee motivation and loyalty
ESOPs motivate employees by linking them directly to the success of the company. As the company grows and increases in value, so does the value of the employee's shares or options, which leads to higher motivation and loyalty.
Employees who have a share in the company naturally have higher motivation and loyalty, as their performance is also indirectly reflected in the value of their share. In this way, ESOPs can contribute to better results and faster growth of a start-up.
2. Attraction and retention of talents.
In a competitive start-up environment, it is important to attract and retain talented employees. An ESOP is considered as one of the most effective methods to attract and retain talented employees, especially in the competitive environment of start-ups. It offers potential employees the opportunity to gain a share in the company's growth, which may be more attractive to many than a high salary or traditional benefits.
At the same time, ESOPs provide long-term employees’ interest in the company, as they often contain terms that restrict the sale of shares or the exercise of options until a certain time. This means that employees have a strong incentive to stay with the company and contribute to its growth.
3. Attractive compensation and improved cash flow
For start-ups with limited funds, ESOPs can be an attractive form of compensation that does not require an immediate financial expense. As ESOPs often include options that are exercisable only after certain conditions are met, this can help start-ups keep their cash flow under control.
An ESOP also enables to offer attractive financial remuneration in the form of shares, which is often less costly than increasing wage costs. Employees are thus offered a success of the company, which is linked to the sale of the entire company (so-called exit) within which they will receive the proceeds from the sale, thus compensating them for the lower remuneration they received when joining the company.
4. Increased attractiveness for investors
Companies with well-designed and managed ESOPs may also be more attractive to investors because they show the management's commitment to employees and their long-term success. Investors often see ESOPs as a sign of a sound company culture where employees are motivated and loyal. This attractiveness to investors can help raise additional capital and improve financing conditions. For these reasons, an ESOP implementation in a company is often the main requirement of an investor entering a start-up.
5. Accelerating company growth
By setting the right parameters of ESOPs and motivating employees, the company can achieve starting up the business and its growth.
6. Tax benefits
Certain forms of ESOPs, when set up correctly, can offer tax benefits for both employers and employees. Tax reliefs and benefits vary by jurisdiction, but may include income tax reduction, tax deferral or capital gains tax reduction. These tax benefits can be attractive to both employees and employers and can contribute to the success of an ESOP.
Whom should we grant an ESOP?
When implementing an ESOP in the company, it is important to correctly identify the key employees and associates who should receive this form of reward. At the same time, it is important what stage the start-up is in and what fields need to be occupied at a given moment. These stages can be broken down as follows:
- Bootstrap, pre-seed, seed stage - at this stage, employees with business knowledge in a given field, IT developers and product managers are essential. These experts are responsible for product development, testing and optimization.
- Series A, B stages - at these stages the marketing, sales and expansion departments are important. Employees focus on customer acquisition, building brand awareness and expanding the business into new markets.
- Start-up growth stage - at this stage, the start-up typically shifts to a performance-based approach, where the best employees are selected based on their performance. The management focuses on process improvement, efficiency, and profit maximization.
Conclusion
In today's post, we defined what ESOP means in general, what benefits it has for start-ups and employees, and when we should use it. In the next post, we'll look at the basic forms of ESOPs, define the important institutes and tools you'll encounter when structuring these ESOPs, and explore the standard parameters applicable in the Czech Republic.
