The ESOP Complex – Part II

In the Part I of this series, we discussed questions around the right option pool size and a framework for identifying the right employees for granting options. In this part, I will cover the key aspects of a good ESOP policy that is employee-friendly as well effective for the company.

What makes a good ESOP policy?

The three critical aspects of the ESOP structure are:

• Exercise price
• Vesting period
• Action in case the employee leaves after vesting some options

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The ESOP Complex – Part I

Exercise price

In the early stages of the company, I recommend that the exercise price be kept at par value (typically Rs. 10) for all employees. Founders have their shares at Rs. 10. Having an exercise price of Rs. 10 aligns the employees with the founders; it is a powerful statement to make to your prospective employees -- if I make money, you make money (this will be true under most circumstances; we will discuss the exceptions later). 

Even in early stages of company’s valuation growth, there will be pressure to increase the exercise price to a level that is close to the per-share price of the last funding round. The argument in favour of this is that the employee should benefit from the price increase from the time she joined rather than being gifted the value already created.

Two points against this: one, the most recent funding round price could change and there could be a down round; in such a scenario, employees with higher exercise price will have very little interest in the options. The second argument is about the misalignment of newer employees with founders and earlier employees. 

As the company matures and valuation grows (possibly beyond $0.5-1 billion), the founders can increase the exercise price to a discount to the most recent financing round. The discount should still be reasonable enough (30-50% such that employees feel money good at the time of joining)

Vesting period

Typically companies have three to five years of vesting period. I recommend four years as the vesting period with 25% vesting each year. Alternative to this is 10:20:30:40 configuration that backends the vesting schedule so that employees have an incentive to stay longer. Among employees who value ESOPs, this schedule will produce hostility. It is good to have an annual cliff for deciding the vesting -- options vest equally at the completion of each year.

Exercise in case the employee leaves after vesting some or all options

Typically the employees leaving the firm are asked to exercise the options within a certain period of time of around 30-90 days. If they do not exercise, the options lapse. The rationale for this approach is: why should someone leaving the firm have it easy with my company shares?

For employees to exercise, they get hit by the tax -- they have to pay tax on the difference between the exercise price and the current value per share. Let us remember this value per share is a notional number with the employee having no control over the liquidity. Taxes are real but the gains remain notional for the option holder.

I recommend the following: let employees keep the vested options with them till the liquidity events (company sale or secondary sale or buyback by the company). Value creation is a journey and not a destination. 

It saves tax cost for the employees; it also saves the compliance cost of increased shareholder management if the employee does exercise the options into shares. It is recommended to take the right legal advice and make sure all documents are in place for future transactions.

In Part III, we will cover handling ESOP conversations with employees