The Legal Viewpoint: How To Structure Your Options Pool

Explore the fundamentals of how employee share option plans actually work, and some insightful guidance on how best to structure your ESOP for success.

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By Suraya Turk • Dec 19, 2022

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Employee share option plans (ESOPs) are becoming increasingly more popular with startup founders. They are a great tool in terms of helping a startup attract and retain key talent to a business, as well as providing employees with potential monetary gain should the startup be successful.

An ESOP sets aside a pool of company shares that can be allocated in the future to employees, directors, advisors, and/or consultants. Employees are therefore much more incentivized to work hard and contribute to being part of your startup's success and growth.

While it may seem a bit overwhelming to establish an ESOP, don't worry. Here, we explore the fundamentals of how ESOPs actually work, and provide some insightful guidance on how best to structure your ESOP for success.

VESTING AND REVERSE VESTING

Share options are usually issued on a vesting schedule, meaning that employees will earn them over time. Typically, this is a four-year period, with a one-year "cliff" built in. The cliff is the period of time that must pass before the first round of shares can be vested. After this, share options are issued in line with the vesting schedule. You can decide whether you prefer this to be monthly, quarterly, or annually.

Another option is to link vesting to specific objectives or key performance indicators, essentially when a milestone sales target is achieved then vesting takes place. Vesting offers great protection for both your investment and investors by awarding shares over time, and not in one fell swoop. Apart from your employees being incentivized and invested in your business over the long term, vesting also helps manage potential dilution by safeguarding shares from employees who leave the business on bad terms.

Reverse vesting occurs when shares are already held by a person, but as the vesting period has not been completed, the shareholder has to transfer shares back to the company. This tends to occur when a founder owns all the shares in their startup. Reverse vesting is a form of protection for a business. For example, a company can avoid the situation of a co-founder leaving the company, while maintaining a large ownership interest.

CLASSIC VERSUS PHANTOM PLANS

ESOPs can come in many shapes and sizes. The two main types of plans are classic plans and phantom plans. Classic plans are the more traditional of these plans, where actual shares are issued to employees, consultants, and advisers. Phantom plans substitute issuing of actual shares with phantom or synthetic shares. Essentially, these are contractual rights that basically offer the economic benefits of holding shares, without issuing any shares.

So, what are the pros and cons of these plans?

Advantages

Disadvantages

Classic Plan

  • Familiar structure

  • Incentivized employees, advisers, and consultants

  • Funds likely to go directly to employees, advisers, and consultants on exit

  • Time-consuming and costly

  • Complicated cap table due to many shareholders

  • Increased documentation and administration in the event of an exit

Phantom Plan

  • Cheap, quick and easy option as no shares are issued

  • Clean and simple cap table

  • Delivers economic benefits to participants

  • Newer concept so participants may need more explanation

  • Cap table and shareholder information needs to be tracked and maintained

  • At exit, startups may have to administer and pay out large cash sums

Related: The Legal Viewpoint: How To Structure Your Startup For Success

OPTIONS VS. SHARES

Clearly, ESOPs offer a potential win-win situation for everyone. So, what are the key points to address when structuring an ESOP to ensure everyone is on the same page, and avoid any potential confusion?

Options are not yet shares; they provide a right to the holder to buy shares in the company at a future date, at a price established at the time of issue. Therefore, they will not show on the company's member register, and these options will not dilute other shareholders.

Option holders are usually simply listed on a register. They don't have any right to dividends, or any right to vote at shareholders' meetings.

DIPPING INTO OPTION POOLS

Option pools do not ringfence a specific amount of shares. When a startup determines the size of the options pool, they are basically informing shareholders of the percentage of the company that may be issued in options in the future.

Shareholders clearly need to fully understand and be onboard with the size of the options pool, and the maximum amount of dilution that will result when options are actually converted into shares.

There is no standard size for an options pool, and the decision on the size of the pool is usually made by the company and its shareholders. Typically, the option pool will not be huge and generally equates to 10-20% of issued share capital of the company at the time of the agreement.

Having a pre-agreed options pool in place will enable a startup to issue options to employees without requiring any additional shareholder consent. It is possible to increase the size of the options pool in the future, but all shareholders must be in agreement, and this needs to be documented.

Investors will be impressed, and potentially more likely to invest, if your startup has an ESOP in place, as they will fully appreciate the value of incentivized staff who are committed to your startup's success.

Therefore, you may be asked by an investor to implement an options pool if there is not one in place. Key considerations here are the size of the options pool and how this will potentially dilute this new investment in the future. Seasoned investors may ask you to determine the size of the options pool in relation to company valuation prior to their investment.

LOOKING AHEAD TO THE FUTURE

When determining the percentage of options you plan to issue to employees, it's important to factor in how you plan to grow and expand the business in the future. Clearly, you want to reward those who have been with the company from day one, but soon, a handful of staff will expand into a larger team, so planning ahead is vital.

Before you decide on a fair percentage, you should look at your company valuation at that time, current benefits, and remuneration the employee is receiving, and the value this staff member offers now, and potentially in the future. As a benchmark:

  • Founding team/original employees (10 staff or less): Early stages may involve giving 1% of the total company equity per employee (10 staff or less)

  • Medium-sized companies (10+ to 50 staff): Options may be given out based on seniority or strong employee performance

  • Growth-stage companies (50+ employees): Allocate options based on employee role and seniority and as a multiple of employee salary

KEY TAKEAWAYS

Well-structured ESOPs ensure that everyone is unified in terms of company goals and objectives and are also extremely attractive to investors.

ESOPs also ensure that the company does not give too much equity to non-cash investor shareholders.

Continually revise how much equity you decide to give away as the company grows and expands, while ensuring a fair equity percentage according to each stage of the company.

Related: The Legal Corner: To Raise, Or Not To Raise? A Lawyer's Guide For Entrepreneurs Seeking Funds To Grow Their Startups

Suraya Turk

Managing Partner, Legal Circle

Suraya Turk is the Managing Partner of Legal Circle, a UAE-based law firm uniquely positioning itself as a frontrunner in the area of technology in the vital sectors. Legal Circle provides startups, SMEs, multinational companies, and government entities with practical and innovative legal and commercial solutions to navigate and develop the regulatory landscape.

As a former Managing Director of international and local law firms in the UAE, and prior to that as an Australian qualified lawyer, Suraya has led law firms and legal specialist teams. She is currently leading and cementing Legal Circle’s strong reputation for being an agile, nimble, adaptive, and innovative law firm which provides practical legal and innovative commercial solutions for clients. 

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