When setting up an employee stock ownership plan (ESOP) for your startup, you might run into the following questions:
- What is ESOP?
- What is a good ESOP example?
- How to get started with my employee stock ownership plan?
- How to create a stock option liquidity plan?
Well, learn about ESOP you must!
Before we dive into the details, it is important to understand that the taxes and legal systems applied to startup stock options can vary per country. Later in this guide, we will take a look at how you can ensure that your employee benefits plan is compliant and set up to run smoothly from the initial grant to the final sale.
What is ESOP?
ESOP (Employee Stock Ownership Plan) is an employee benefit set up by the company (usually a startup) to grant their employees an ownership stake in the business.
Usually, ESOPs are given in the form of company stock options.
5 TOP reasons why companies grant stock options:
- To give employees additional forward-looking compensation on top of their monthly salary.
- High-level hires offered stock options in high-potential startups are more likely to accept the offer.
- Employees who are given stock option grants are more likely to feel ownership of the company’s success.
- Startups with strong ESOP plans report higher employee satisfaction and retention.
- Team members can gain liquidity from their options when the company makes an exit or during pre-exit investment rounds.
For many employees, the only opportunity to understand the real value of their ESOP plan and gain liquidity from their options comes at the company's exit.
A growing sentiment in the sector is that giving the employees more chances to cash out their ESOP shares via secondary sales adds an invaluable layer.
The State of ESOPs in 2023/2024
Alright, the stock option plan sounds like a good idea. But is the timing – 2023 and 2024 – the right time to set up your employee incentive plan?
According to Carta, there was a significant decrease in early-stage startup investment at the beginning of 2023. However, the Q3 shows a strong recovery trend.
But going from stock option grant to sale doesn’t happen in 12 months. Rather, it can take 12 years for a startup to achieve success and go public on the stock market.
Most ESOPs in the EU have liquidity (sale) events for employees upon the company's exit, meaning the sale of shares or a company IPO. As data from Industry Ventures reveals, 2021 was a record-breaking year for IPOs and M&A, yet only 209 unicorns either went public or were acquired.
That’s why the value of ESOP is the employees’ ability to get cash from them or use them for long-term investment. In 2021, the average company that went public was 12 years old and generated $200 million in annual revenue, compared to only 6 years old and $30 million in revenue in 1989.
TL;DR: Yes, 2023 and 2024 are a great time for setting up an options plan. The slow economic outlook now doesn’t necessarily affect your company’s long-term success. You should create an employee stock option plan early in your company’s lifecycle.
In the US, ESOP plans are typically set up after the seed round and sometimes earlier. The legal costs are low. In the EU, the cost of setting up an equity plan is often higher, and it’s not uncommon to see ESOP plans created after Series A fundraising.
Important! After setting up your ESOP plan, make sure to keep your team excited about their stock options. Salto X has launched several free tools for HRs and Recruiters and the C-suite to better educate and engage the team with ESOP plans. Sign up and try them for free.
How to set up an ESOP plan?
The Employee Stock Option Plan is initiated and set up by the company’s management. Some startups prefer to grant equity to all employees, while others restrict share option awards to the management and high-performers.
An ESOP is set up as a trust fund. The company may grant newly issued shares, borrow money to buy company shares, or fund the trust with cash to purchase company shares. Meanwhile, the enrolled employees can accumulate a growing number of shares over time.
The average size of ESOP pools range from 10% to 25% at all stages, with the total allocation increasing steadily as the company grows and hires more employees.
Your board will have to approve your ESOP rules. So it’s important to make them as clear and consistent as possible – avoid changing them later.
How to sell stock options via ESOP?
Another question that often comes up is: how to turn the stock options into cash?
In order to sell the stock options, the employees need to wait until they’re vested. And even the vested stock options can’t be exercised and sold without a liquidity program before the company's exit.
Introducing the ESOP Liquidity Program
Recognizing the gap between employee expectation and reality, it's timely for companies to either introduce a secondary sale or an ESOP liquidity program. Such a program is not only a long-term solution for those querying, "How do stock options work?", but also an immediate avenue for employees to sell shares.
An ESOP liquidity solution often allows employees to sell a portion of their ESOP shares for cash, well before the expected cliff or liquidation period.
It is crucial to differentiate between primary and secondary sales: while the former sees an investor buying company shares to fund growth, the latter involves an investor purchasing employee shares, with the company facilitating the sale. Thus, the ESOP liquidity program caters to employees keen on exercising stock options, allowing sales to company-approved investors.
How to set up an ESOP liquidity program?
Setup check-list for ESOP liquidity programs:
1. Set up rules for the liquidity program by defining:
- Who can participate in it? Would these be current employees, ex-employees, or both?
- What proportion of shares will each employee be able to place for sale?
- What will the price per share be?
- How often will be the liquidity events or liquidity windows via the liquidity program, or is it a one-time thing?
- How will the transaction process be managed, and by whom?
- What are the responsibilities of each party before, during, and after the transaction?
- Define who will cover transaction costs like legal advice, tax advice, and similar.
- Set other terms.
2. Find and approve potential buyers, do the due diligence, negotiate the price of the shares, and agree on the amount of shares to be the subject of the transaction.
3. Alternatively, the company may decide to do the buyback of shares itself, which is still liquidity but provided by the company – a tender offer. Very often, it requires careful planning and building cash reserves for the company to be able to buy those shares from employees. In addition, some jurisdictions may have restrictions on how many of its own shares a company can hold.
Generally, an ESOP stipulates terms related to exit events, i.e. when employees can monetize their ESOP shares. However, an ESOP liquidity program can introduce more opportunities or specific periods for employees to sell shares prior to a set exit event.
Setting up such a program involves determining participation criteria, share price, sale proportions, frequency of liquidity events, and handling responsibilities at various transaction stages.
Primary sale occurs when an investor buys company shares; in return, the company receives money to keep growing.
Secondary sale occurs when an investor buys employee shares. The money goes directly from the investors to the employees, and the company is just a sales facilitator.
Thus, the ESOP liquidity program allows employees who hold shares to sell them to investors approved by the company or directly to the company via secondary sales and under the rules of the liquidity program.
Broadly speaking, ESOP pools range from 10% to 25% at all stages, with the total allocation increasing steadily as the company progresses.
Example of ESOP liquidity plan
For example, imagine a company called Happy Place LLC.
The full ESOP lifecycle:
- Happy Place LLC introduced an ESOP in 2017, which is an essential component of equity compensation.The ESOP came with a vesting schedule of 4 years. Eager to understand "What is an ESOP?" and "How do stock options work?", numerous employees opted to participate in the ESOP plan.
- By 2021, all the initial employees had fully vested stock options. Thanks to a Stock Options Calculator, they realised the consequences of exercising stock options. Consequently, they could purchase shares at the predetermined strike price, transitioning from employees into shareholders of Happy Place LLC.
- Between 2021 to 2024, these stakeholders held their shares without any chance to liquidate. Some of them even moved on from Happy Place LLC during this period.
- The company didn't foresee an exit or IPO until perhaps 2030.
- However, realizing that employees couldn't grasp the tangible value of shares on paper, Happy Place LLC rolled out a liquidity program. This program included two liquidity windows in 2025 and 2027. Therefore, Happy Place LLC undertook a strategic initiative to enable a secondary transaction as part of a structured liquidity scheme for employees.
- In 2025 and 2027, some employees used an opportunity to cash out, which made a real-life example for other employees to see the actual value of stock options and served as an employee retention strategy for Happy Place LLC as an employer.
Recognizing employee requirements and distinguishing them from shareholder needs transformed the company's ethos from an "us versus them" mentality to an inclusive "we're all in this together" approach. Moreover, this move also paved the way for prominent VCs and secondary funds to invest in Happy Place LLC prior to a potential IPO.
The Benefits of an ESOP Liquidity Program
Once the inaugural secondary sale is complete, there's a noticeable uptick in employees discerning the true worth of equity through their Employee Stock Option Plan. This newfound knowledge invariably leads to enhanced employee engagement. Manifesting the company's empathy towards its employees' fiscal aspirations, and offering avenues to profit from the ESOP, can foster loyalty and employee retention.
By showcasing the company's commitment and care about employees' well-being, an ESOP can also become a compelling incentive to potential new hires. Word of mouth travels fast, and current or ex-employees talking well about the company has proven to boost employer branding. In addition, it might reduce some candidates' hesitancy about joining a company with an ESOP due to concerns about illiquidity.
Although in the short term, the company may see the ESOP liquidity program as an additional cost center, in the long run, it is proven to align the interests of the company with the interests of the employees and enhance overall satisfaction with the workplace.
So why stop halfway with ESOP if the company can use this incentive at full capacity and enable the ESOP liquidity program?
It's important to note that implementing an ESOP liquidity program requires careful planning, legal expertise, and compliance with relevant regulations, including those outlined by the securities laws. As such, companies considering introducing such a program should consult with experienced professionals who specialise in ESOPs, employee benefits, and securities law to ensure the program is established in a legally sound and well-structured manner.
How to choose an ESOP management tool?
Managing the company’s ESOP plan and making it understandable and transparent for the employees is best done with the help of a stock option management platform.
An ESOP management tool will help you with:
- Setting up the stock options plan
- Managing and granting employee equity
- Giving employees a 24/7 overview of their stock options
- Educating employees on their stock option value and benefits
- Educating employees on stock option vesting and sales
- Calculating the tax on stock options in different markets
Get started with Salto X ESOP management platform for free. And talk to us to resolve any outstanding questions – we’ll help you to get it sorted!