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The Employee Stock Option Plan (ESOP) Guide
Oct 24, 2023
What is the Employee Stock Option Plan (ESOP), what are some key terms for employees to be acquainted with and how can we estimate the value of stock options?
These are some topics that will be addressed in this blog post with the aim to provide a bit of color, and hopefully help operators: founders and startup employees, better understand the mechanics, as well as the value of their options.
What is an ESOP?
The ESOP is an earmarked part out of the total shares of a company. This “pool” of shares is designated for employees, who are typically early joiners, key employees, management or C-level.
An ESOP is usually created when a company completes a funding round, and is typically required by institutional investors. In early-stage companies this Plan of shares is usually in the range of c.10% out of the total shares of the company.
The ESOP can be replenished in later funding rounds by issuing a “top-up”, since naturally a significant part of the Option Plan would have been already allocated to employees. By topping up the ESOP it is ensured that there is an unallocated part of stock options that is available to be offered to attract new key hires, as well as retain and further incentivize existing key employees. That being said, the ESOP should be offered with care (since it can end up being an expensive form of compensation) while as mentioned it is a good idea to keep at all times an unallocated part available.
The rationale behind the ESOP is that key employees can be incentivized, retained, and aligned with all stakeholders i.e. founders and investors, as well as rewarded for their contribution in the growth of a company. The ESOP also functions as a “bonus” component of the compensation package in addition to a base salary. Given startups are often conscious of their cash burn, stock options are a way to reduce fixed salary costs while offering a more attractive compensation package to employees.
Main terms, mechanics and rationale
When an employee comes across a Stock Option Agreement for the first time, there are often several unknown terms. We will go over these main terms and explain the mechanics and rationale in as simple way as possible:
Vesting Period: the time period required for the total number of stock options granted to an employee to fully “vest”. The most standard vesting period is 4 years, even though of course this can be shorter or longer. As an example, if an employee is granted 100 stock options with a 4-year vesting then after 1 year they would have vested 25 shares (so 25% of the total shares granted), after 2 years 50% and so on until the end of year 4 by when all 100 stock options would have vested. The rationale of vesting is that an employee is not given from their first day at work the entire benefit of 100% of the stock options granted. Instead as time passes, and employees contribute to the company, they accumulate stock options that vest. Lastly, some stock options have accelerated vesting which applies if there is an exit. In that case even if say 4 years have not passed but there is a trade sale or IPO of the company, then automatically 100% of shares would vest to the employee.
Cliff: a 1-year cliff is yet another standard term. This means that if an employee leaves or is let go before they complete at least 1 year in the company, then they lose all their stock options. If an employee leaves or is let go after their 1st year then they can retain whatever percentage they have vested until that point. So, if an employee leaves in year 3, they can retain 75% of their stock options based on the previous example of a 4-year vesting period.
Vesting Schedule: is the frequency of vesting that dictates how often the stock options vest i.e. monthly, quarterly, semi-annually or annually. As an example, if the vesting schedule is monthly then after say 2.5 years (so 30 months) an employee with a 4-year vesting period would have vested 30 out of 48 months i.e. 62.5% of their stock options.
Strike Price: this is the price at which the stock options can be exercised i.e. bought by the employees. The strike price is payable for the stock options that have vested and are able to be exercised. Typically, the strike price is set at a significant discount compared to the price per share of the latest funding round. As an example, if we assume that the price per share paid by investors in the latest funding round was $10 per share, then the Strike Price could be even $2-3 per stock option. This heavy discount is to give some benefit to employees from the get-go while protecting them to a certain degree in case of future decreases in the price per share. The rationale of the discount can be often tied to the valuation of the company given by the respective tax authorities, which is heavily discounted against the market valuation given by investors. Often employees joining at a later stage get higher strike prices compared to early joiners, since they joined later and hence will contribute to the company’s growth from that point onwards. Similarly, a key employee might get additional stock option packages at some point after their initial vesting package is coming to an end. This additional stock option package most likely will have a higher strike price than the initial one.
Issue date: the date the stock options are granted to an employee. However, what is more of interest for the employee is the date from which the vesting starts. Typically, this would be the first day of the employment contract. That being said, this date can be backdated, or it can also be an arbitrary date. For example, let’s say an employee joined in January 2022 and after having proved they are a key member of the team, they are granted some stock options in June 2022. The vesting start date could be “backdated” to start from January 2022 in order to take into account the entire time the employee has been with the company. Similarly vesting can also start from some point in the future and does not have to match the first day of the employment contract but can be tied to a funding round and the creation of the ESOP.
Exercise date: is the date that Stock Options are exercised. Only vested stock options can be exercised by paying the Strike Price (a cashless exercise may also be possible but that is more of a technicality). This typically occurs when there is a liquidity event for the company. This can range from an IPO to a trade sale or even a funding round where investors buy shares sold by founders and employees (called secondary since they are not newly issued shares). As a side note, we have to mention that some companies have certain restrictions in terms of the date of exercise. For example, if an employee leaves a company they need to decide if they want to exercise or waive their stock options within a fixed time period. If they decide not to exercise, then these stock options would go back to the Stock Option Plan of the company.
Stock Option: last but not least a stock option is the option but not the obligation to buy X number of shares (depending on how many stock options an employee has vested) of a company by paying the Strike Price.
How can I estimate the value of my stock options?
The “actual” value of stock options would be determined once the employee exercises them and acquires company shares by paying the strike price. Following that they can sell the company shares they acquired and realize a profit.
However, employees naturally want to understand the value of their stock options at different points in time. Hence, we will use a worked example for ease.
Let’s assume that an employee is granted 10,000 stock options with a 4-year monthly vesting and a 1-year cliff at a strike price of $3. These numbers are indicative.
Estimated Value once granted: calculated based on the latest price per share of the company minus the strike price that has to be paid. If we assume the latest price per share is $10 then the estimated value of the stock option package when granted would be 10,000 stock options x ($10 (latest price per share) - $3 (strike price)) = $70,000 i.e. an equivalent of a $17,500 “bonus” per year.
Estimated Value at some point in time: calculated based on the latest price per share minus the strike price, plus we can now also calculate the vested part. Let’s assume that some time has passed, and additional funding rounds have been completed and now the latest price per share is $20. This means that the value of the stock option package would be 10,000 stock options x ($20 (latest price per share) - $3 (strike price)) = $170,000. If we assume that say 3 years have passed in a 4-year vesting period, then 75% of the stock options would have vested and hence the value of the vested stock options would be 75% x $170,000 = $127,500.
Estimated Value at exit: calculated based on the price per share that the company is sold at (in case of trade sale) or the employee sells at (in case of secondary sale) or trading at (in case of IPO and trading in the stock market). If we assume the price per share upon exit is at $30 then the estimated value of the stock option package would be 10,000 stock options x ($30 (price per share) - $3 (strike price)) = $270,000 i.e. an equivalent of a $67,500 “bonus” per year.
How to think about stock options?
Stock options can be viewed as a “bonus” element in the compensation package of a key employee. In the above worked example we have the price per share of the company growing from $10 per share when the stock options were granted, to $30 per share upon exit. Hence there was a 3x increase in the price per share. But how can we translate this in terms of company valuation?The answer is not so straightforward, since it does not mean that if the price per share increases by 3x the company valuation (say valued initially at $20 million) has also increased by 3x to $60 million. The reason is that as funding rounds take place and investors inject more capital in the company, existing shareholders (including stock option holders) get diluted due to new shares being issued. Company valuation is the product of # of outstanding shares x price per share. So at 3x increase in price per share would mean a higher than 3x increase in valuation, due to more shares being issued.
As an example, if we assume that 3 rounds of an average 20% dilution will happen between the time the stock options were granted and exit, this means a total dilution of 1 - (1 - 20%) ^ 3 = c. 50% dilution. This in practice means that the valuation should grow by more than 3x in order to “compensate” for this dilution. Specifically it should grow by 3x / (1 - 50%) = 6x. Hence the exit valuation would reach $20m x 6 = $120 million for the employee to exit at $30 per share and get a “profit” of $270,000 based on the above example.
There is no free lunch and hence no reward without risk. Stock Options are not a cash bonus and hence their value is not guaranteed, but as per the above example they can also appreciate significantly. As mentioned previously, there is typically a large discount in the strike price to begin with, hence giving a head start to employees in terms of their theoretical value at the point the stock options are granted.
That being said, in many cases we have seen employees in outlier companies get a great result from their options that is multiple times their annual salary. We would urge employees to ask, and companies to provide options to align and incentivise their teams. This also creates a great culture, one of sharing the outcome and better aligning the team, the founders and all stakeholders.
Closing points
Both companies and employees will need to consider the rules for ESOPs and capital gains for how they treat and value options. There are tax elements, depending on the type of Stock Option, jurisdiction etc. that should be considered separately.
p.s. in case of secondary sale i.e. stock options sold by employees typically as part of a new funding round, it is common that a 5-20% discount is applied in the price per share compared to the latest price per share of the company. The reason behind this is that stock options are tied to Ordinary Shares that are less senior in terms of rights compared to Preferred Shares that are the shares investors get in funding rounds.
