Overview of Employee Stock Option Plan (ESOP)
Options keep your team incentivized by letting employees, contractors and directors purchase shares and participate in the company’s long term success.
The Employee Stock Option Plan (ESOP) sets aside a portion of the company's shares so they can be awarded as options to employees, contractors and directors. Options allow the people who contribute to the company's success to purchase shares in the future at a favourable price. This incentivizes employees to commit themselves to the company, as they will benefit over the long term just like the company's other shareholders.
Most early-stage companies with plans to grow their workforce and scale operations create an ESOP. It is a key inventive that will help companies hire top talent. When an early-stage company cannot match the salaries paid by established industry leaders, options provide a lucrative form of compensation.
The Option Pool holds all shares that are set aside for options. Creating a pool confirms that the company is committed to providing options to employees. Founders will usually try to establish a conservatively sized pool to avoid diluting their ownership (for example, 10% of shares). Investors and other stakeholders might push for a larger Option Pool (20% or higher) to ensure employees will always be fully incentivized to work at the company.
Shares in the Option Pool can't be used for any other purpose so long as the Option Pool exists. The Option Pool will appear on the company's cap table as if these shares no longer belong to the company's founders.
To change the size of the Pool in the future, the ESOP will need to be replaced. This can be initiated through your Founded account and will require the approval of the company's board of directors.
The Option Pool contains only one class of shares. This is nearly always a non-voting share class, as it is unusual to give employees the right to vote as shareholders once they exercise their options.
Given that the overall number of options is limited to what is in the Option Pool, options come with definitive timelines for expiration. This ensures if an employee doesn't want to convert the options into shares, that the company can re-issue the options to another employee.
The most common expiration date happens when an employee leaves the company (either through resignation or termination). In this case, the employee will have a certain number of days to exercise the options and purchase shares. If the employee does not act within the set timeline, the options will expire and get returned to the Option Pool. These timelines are strict and need to be observed by the employee in order to avoid losing out on the options.
The other common expiration timelines is when an employee's options have fully vested. In this case, the employee needs to decide whether to exercise the options and purchase shares. An employee cannot just "sit" on the options. If the options are not exercised after fully vesting, they will be returned to the Option Pool. Most companies give employees one year to exercise options after they have fully vested, but the specific timelines will be in the ESOP.
The Exercise Price (also called a "Strike Price") is the price the Optionee will have to pay to purchase shares in the company after the options have vested.
The company can determine the Exercise Price (which will be included in the Option Award Agreement) but the price must reflect the actual value at the time the options are granted (not when they are exercised). So when awarding options to employees, the company must do a realistic assessment of the current fair market value of its shares. After options are awarded to employees and vest over a matter of years, the employees will benefit from having the option to purchase shares at the Exercise Price, which will be a significant discount to the then-current value of the shares after several years of growth.
If the company's shares decline in value, unfortunately the Exercise Price will be higher than the current value - so options are never entirely risk-free.
Options are usually intended to encourage employees to make a long-term commitment to growing the business. With vesting provisions, options are distributed to employees gradually over a set time period. The longer the employee works at the company, the more options they will receive.
There are two important elements to the terms of vesting: (1) the Cliff Period, and (2) the frequency of vesting.
The cliff period is the time before any of the options can be exercised (meaning, they can't be used to buy shares). This is the minimum amount of time the employee must contribute to the company in order to become a shareholder. It is quite common for a company to set a one-year cliff period, so if the employee resigns or is terminated in under one year they will not actually receive any options.
Frequency of Vesting
The second important consideration is the frequency that options will vest to after the cliff period. Some companies choose to make vesting an annual event. So, with an annual vesting frequency, each year a certain number of options will vest and can be used to purchase shares.
More commonly, companies choose for options to vest on a monthly basis. This means that each month a fraction of the employee's option will vest. Monthly vesting allows for a precise vesting schedule that reflects the true amount of time the employee has committed to the company.
If the company is acquired while options are vesting, employees could miss out on the opportunity to obtain shares in the company. So some employees request "accelerated vesting" provisions in their Option Agreement. Accelerated vesting provisions allow for all options to immediately vest if the company is acquired.
The company always has discretion to allow for immediate vesting, but accelerated vesting provisions will make it a legal requirement for the company.
For example, if an employee has 300 vested options and 200 unvested options at the time the company is acquired, the employee will be permitted to obtain only 300 shares (the vested amount). However, if the Option Agreement has accelerated vesting provisions, all 500 options will become available at the time of the sale, which will be beneficial to the employee.
Ordinarily, when an employee resigns or is terminated, new options will no longer vest but the employee will have a reasonable amount of time to decide whether or not to exercise any vested options. This general rule applies for any resignation of any employee or director and to any situations when termination is "without cause".
However, options are treated differently when an employee is terminated "for cause". Termination for cause usually requires some serious misconduct on the part of the employee or director. There is a very high legal standard to prove misconduct. If there is a proper basis to terminate for cause, all vested and unvested options will be cancelled immediately. The employee or director will not be able to exercise the options they have earned while working for the company.
In the event the employee or director has already exercised options, it is possible to demand that they surrender those shares without any compensation due to the harm they have caused to the company.