PS#092: Employee Stock Ownership Plans (ESOP) – Overview (Part 1)
After popular demand, we’re going to talk about employee stock ownership plans (“ESOP”).
When it comes to building a startup, ESOP are a critical part of driving overall success. While founders might be the ones to get an idea of the ground, it’s the building of an elite team that allows companies to scale to the size of current tech giants (i.e., Google, Microsoft, Amazon, etc.).
If this has been a confusing topic for you in your journey through startup land, you’re not alone. Early in my career, I struggled with understanding how all of this worked and, even more importantly, how much it mattered.
Over the course of the next few issues, I’m going to walk through the importance of ESOP and how to think about it (both as a company and as an investor).
For today, we’ll discuss…
What is an employee stock ownership plan?
How do employee stock options actually work?
Why does employee ownership matter?
Alright, let’s get started.
What is an employee stock ownership plan (ESOP)?
An ESOP allows companies to issue stock options to their employees, granting them the right to buy shares for a predetermined strike price at a time in the future.
Employee ownership is often used as a form of compensation (alongside cash) to incentivize and align employees with the goals of the startup.
This is a very standard practice within the world of startups, so much so that we have companies (e.g., Carta, Pave, etc.) that are benchmarking the amount of cash and stock compensation that a typical employee will receive at a certain role, level, etc.
How do employee stock options actually work?
When an employee is hired (or during their tenure at a startup), the company will provide a package of compensation. This will typically include some combination of cash and stock as we discussed earlier.
As with all employment agreements, the ESOP grants (or stock options) will be provided via a contract that lays out the details of the stock compensation, including…
Type of stock option
Number of shares (that can be purchased)
Strike price
Vesting schedule
Let’s dive into these items in more detail…
Type of Stock Option
There are two types of stock options…
Incentive Stock Options (ISO)
Non-qualified Stock Options (NSO)
The difference lies in the tax treatment. ISOs receive preferential tax treatment when exercising stock options that are already “in the money” (i.e., meaning they have increased in value). This is the one that is typically used for employees.
Number of Shares
The contract will also indicate how many shares the employee can purchase at the predetermined strike price. This is where the compensation benchmarking companies (e.g., Carta, Pave, etc.) come into play. They will help companies figure out how many shares an employee should receive for a specific role, level of experience, tenure, etc. based on the market.
Strike Price
The strike price is the price that an employee can buy the shares outlined in their stock option grant. This price is based on the fair market value (“FMV”) of the shares. For private companies, the FMV is determined by using a 409a valuation, which is an independent appraisal of a private company’s valuation (or FMV).
Vesting Schedule
In order to properly align incentives, startups use a vesting schedule with their stock option grants. Vesting is the process of earning the stock option grants over time. Most startups use a standard one year “cliff” and then a monthly vesting schedule over the remaining four year period.
In other words, after the first year, an employee will have vested (or earned) 25% of the stock option grants offered to them (this is the “cliff”) with the remaining 75% being earned on a monthly basis after that point (i.e., ~2% per month). To be clear, prior to that first year “cliff”, the employee will not have earned any of the stock options.
Vesting is a tactic used to incentivize the employee to stay, making part of their compensation contingent on remaining with the company for a certain period of time. After the stock option grants have vested, the employee can exercise these options at the predetermined strike price.
Why does employee ownership matter?
At the end of the day, the most important part of any startup is the talent (or the team).
While founders might get an idea started, they are only able to reach scale by building a strong team. Of course, with less cash at their disposal, it can be harder for startups to attract top tier talent with cash compensation alone.
That leaves one clear alternative – ownership.
Employee ownership helps founders and startups…
Hire top talent with equity that could be worth significantly more in the future than current cash offers from other companies with deeper pockets
Retain employees with vesting schedules, the potential of appreciating stock value, and the ability to issue issued even more options to retain top performers
Motivate employees by tying the individual’s impact to increasing the value of the company (and their stock compensation)
Align employees (and all owners) towards the same goal – creating a successful and valuable company
Over the next few issues, we’re going to talk about how startups and investors should think about ESOP over the lifecycle of a company.
