[5 minute read]
Let’s start with the basics.
What is an ESOP?
ESOP stands for Employee Share Option Plan.
An ESOP is a method of offering equity (or ownership) to an employee (or contractor), over a period of time.
An ESOP is a type of an Employee Share Scheme (ESS). However, the difference between an ESOP and an ESS is that in an ESOP, the employee initially receives options, instead of shares.
At a high level, an ESOP works as follows:
- the employee or contractor receives options (or rights) to be issued shares,
- as long as she/he complies with the rules of the ESOP (Plan Rules).
While there are multiple variations of Employee Share Schemes around, ESOPs are the most common form of employee incentivisation for small and start-up businesses.
Where an ESOP is provided under the ‘Start-Up Tax Concession’, it can provide a tax efficient way for employees to be rewarded for their efforts, and can allow an employee to benefit significantly from any increase in the company’s value over time.
Why should you set up your ESOP now?
1. Retain talent when you need it most
If you have talented people on your team, now is an important time to make sure they will stick around. While it is true that there may be a lot of applicants for jobs in a recession, it doesn’t mean that it will be easy to replace talent.
Additionally, hiring during a downturn can really cause disruption to the business where all hands are needed on deck.
Most ESOPs are subject to vesting rules that encourage employees to stay with the Company.
For example, the standard vesting conditions are that the employee needs to remain engaged
- for at least 12 months to vest 25% of its options, and
- the remainder will vest over the next 3 years.
2. Attract talent among the noise
If you are in a position where you need more staff, it can be difficult to attract the right person.
Not many start-ups can lure talented staff with high cash salaries and corporate bonuses (shock horror).
By including options as part of a remuneration package, not only are you able to attract staff that are seeking higher pay, but you can attract staff that are joining the company with the end goal in mind – increasing company value and scaling.
While offering high cash salaries can encourage talented ex-corporate staff to get on board, it doesn’t mean they will be incentivised to stick around. Where they are keen to join the team and to be offered options, it is a good indication that they believe in the company and the vision.
3. Substitute pay-cuts in a meaningful way
No founder likes making pay-cuts. However unfortunately for some companies in hard-hit industries, some have not had a choice.
Where you are forced to reduce the salary of staff to weather the stormy economic conditions, you can ‘top-up’ their packages with options. Not only does this allow you to get all of the other ESOP benefits, but it allows the employee to feel equally valued by the company.
It may also increase employee trust and respect in the founder/CEO, with the employees recognising them as a team-focused leader. Sharing is caring.
Additionally, this ‘top-up’ may in fact end up better off for the employee anyway, largely due to the tax concessions that can apply.
4. Early bird gets the worm
While it is true you can always hold off on setting up the ESOP until you are ‘more established’ or ‘the time is right’, it will actually be administratively easier to set it up early.
For example, if an option pool isn’t already permitted by your shareholders agreement, you may need to get shareholder approval to implement it. It is best to do this while your cap table is small.
Investors in Seed Rounds will often also want to see that you have an ESOP accounted for in your cap table (and perhaps also that you have already made offers to the key employees). They appreciate the value an ESOP can provide to a motivated start-up. It is logical to get the ESOP organised before the raise round, as we all know there is enough to do to prepare for a raise already.
And lastly, just because you set up the ESOP now, it doesn’t mean you need to allocate all of the options right away.
For example, if you set up a 10% option pool, you can just start with making offers in respect of 2% of that pool for now, and save the rest for later.
5. Let your employees start thinking like founders
This one goes without saying. The sooner your employees start thinking like company founders (rather than employees), the better.
During bumpy economic conditions, being innovative, agile and resilient is extremely important.
Once an employee starts working for the greater good of the company (rather than just for their paycheck), these traits will naturally come to life.
Cake makes equity easy
Keen to learn more about ESOPs? Download the free Cake ESOP Guide now.
The Cake software allows you to set up and manage an ESOP in a matter of hours, not months.
Cake allows you to:
- create and approve Option Pools, Plan Rules and Offer Letters,
- send Offers for electronic signing
- make ‘Top-Up’ offers,
- and automate all of the ongoing admin including automated vesting and communication.
You can also purchase fixed fee legal packages to run the ESOP for you from start-to-finish.
Keep in mind that while an ESOP suits a lot of start-up companies, it will not be right for all situations. Feel free to book in a free chat with Cake Legal about how an ESOP could work for you, today.
This blog is designed and intended to provide general information in summary form, for general informational purposes only. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice, are not intended to be a substitute for such advice and should not be relied upon as such