Strategies to setup ESOP for your startup

In this article, we will examine how to set up ESOP in startups, evaluate the benefits of having ESOP in startups, and understand how to structure ESOP for your startup.

Employee Stock Ownership Plans (ESOPs), which originated in 1974, has grown significantly, and for start-ups, it became popular in 2020. We’ve seen great startups all across the world provide them to startup employees. There are about 7,000 ESOPs in the United States alone, with roughly 28 million members of the company engaging.

Is it a viable alternative for your venture? There are several factors to take into account, as well as numerous incentives to select an ESOP. Labor management ownership through an employee stock option plan could be a part of employee benefits to drive the motivation for the company’s future success. In this article, we will examine how to set up ESOP in startups, evaluate the benefits of having ESOP in startups, and understand how to structure ESOP for your startup.

Employee Stock Option Plan for Startups

The most common reasons for businesses to provide employee stock option plans are to attract, preserve, and incentivize talent, boost employee involvement, and distribute the wealth gained. We can answer who ought to be included with the link to why they’re offered. ESOPs should be given to prospects you want to attract, retain for a longer period, or motivate in addition to their usual income, based on the aim. They are frequently used as a distinct component of remuneration. Let us begin by understanding an Employee Stock Option Plan deeper.

What is an employee stock option plan (ESOP)?

Employee Stock Ownership Plan is a U.S. law-controlled federally authorized part of employee benefits. Since parts of the initial ESOP legislation were created in 1974, over 25 subsequent statutes have been enacted to encourage and improve its advantages. Stock options are used to deliver a share allocation to employees in the future. An option is a right but not a requirement to acquire a particular amount of a company’s shares at a predetermined price for a given period of time.

ESOPs provide entrepreneurs with a tax-efficient way to distribute an entire or a portion of their stock to staff over a defined period of time in the form of stock opportunities. An employee stock ownership plan provides the additional advantage of stimulating employees to boost profits and sales as they grow into owners.

How does an employee stock option plan(ESOP) work?

The business creates an employee stock option plan trust, and the corporation could either grant funds to purchase shares from an existing owner or invest directly into new ones with cash. The stocks are purchased with no more than the fair market value. If somehow the shareholdings have lost value or the owner does not wish to sell them, the company will give out more stock. When an ESOP is set up, it doesn’t imply that the business can’t go public or be sold at a future stage.

When shares are sold to employees, they are retained in the trust, and the staff members get rightful possession, but the selling shareholder usually keeps control. As the employee stays for more time with the company, participants get more rights to the stocks. This is also called “vesting“. Whenever an employee quits, they get their shares, which the corporation has to rebuy from them at fair market value, except if the shares are traded in the marketplace. So, the staff usually gets money from the trust for the worth of their stocks.

Why should startups use ESOP to train talent?

An employee stock ownership plan is a significant way for startups to motivate their employees and find good people to work for them. By including them in employee benefits, ESOP makes employees feel like they own the business. These perks can be utilized to incentivize and keep the employees for longer periods and to ensure that everyone works to improve the firm’s performance and earn more revenue.

Employee stock option plans are indeed advantageous to businesses because they help them keep their best employees and preserve their talent. Return on investments and equity is how businesses measure their performance, while net assets turnover, revenues, and liquidity per employee are how they quantify their productivity. So, ESOPs are beneficial to a business and its employees’ efficiency.

Advantages and disadvantages of ESOP

Employee stock option plans can be a costly method that should be used with care. Let’s look at some of its pros and cons to determine whether it’s right for you. Let’s begin with the advantages:

Advantages and disadvantages of ESOP

  • Long-term benefit – ESOPs are good for employees in the long run. They can be an attractive part of an employee benefits package, just like a favorable health care scheme or good paid time off. They can assist a business hire the best people. As shares rise in value over time, these benefits could indeed assist team members in creating a lot of wealth.
  • Shared duty to succeed – ESOPs help employees feel like they own the company, collaborate with one another, and stay with the company. They can be great for staff motivation because everyone has a stake in the company’s overall success. When colleagues think ahead and work hard to do their jobs well, both they and the company benefit.
  • Ownership transfer options – Employee stock option plans help change ownership right away or over time. The existing owner of a company could indeed decide if it’s ideal to sell all of their shares all at once or to stay on as a partner and make the change slowly over time. Also, utilizing ESOP to make a minority stake for liquid doesn’t stop an owner from selling the business in the future.
  • Quicker selling options – Employee stock option plans are a quick way to sell the equity of the company. They can be quicker to execute than an external sale. An outside, the third-party transaction can be a time-consuming procedure with several moving parts. As a result, an ESOP may be an appealing option for owners who want to exit the company quickly.
  • Tax benefits – Employee stock option plans help with taxes and investments in a big way. Since they are tax-free trusts, the business earnings go to the employees, and that’s just the start. A 100% employee-owned corporation does not have to pay the tax, which means it can make more money right away. Talk to a tax expert to learn more about this.

The benefits of ESOP are very attractive, and start-ups have the potential to attract the best talent who can leverage their skills to quickly scale the company. However, they come with their own share of disadvantages. They are listed as below-

  • Size of your business matters – These employee benefit plans are not suitable for small enterprises. Employee stock option plans may only be utilized in C- and S-businesses, not in collaborations or the majority of professional corporations. The working capital committed to it can restrict what is available to invest in day-to-day operations, which can be difficult for early-stage enterprises. And because stocks must be bought back whenever an employee quits, a small firm may face a significant future expenditure if multiple team members leave simultaneously.
  • Transitioning ownership can be risky – To thrive throughout an ESOP transition, businesses must have excellent management. There is a lot on the line when the present owner leaves top management, particularly if they created the firm. Shifting the ownership needs great prospective leadership.
  • Might not present a maximized opportunity to transfer ownership – The revenue generated from a sale to an ESOP may not be maximized by existing shareholders. Since its nature as a financial buyer rather than a strategic buyer, it is limited to offering the present proprietor fair market value. In comparison, an opposition can pay a higher price to purchase the firm, and the present owners may earn top cash.
  • Employee stock option plans need continual management and experience – They have a number of related expenditures, ranging from yearly valuation and plan administration to legal and perhaps trustee fees.

Common terms to know before setting up ESOP

If startup owners decide to set up Employee stock option plans as a part of employee benefits after careful consideration of the pros and cons, they must get a clear understanding of some common terms:

  • Number of shares – The total number of options issued to an individual employed at a company or the maximum amount of shares available to that individual.
  • Strike price – The buying cost that the employee will cover for every share if and when the individual wants to utilize the option.
  • Expiration date – The deadline for exercising the options and converting them into ordinary shares by the staff member.
  • Vesting period – The time period during which the individual’s options are fully possessed and executable and are no longer entitled to buyback by the corporation.
  • Cliff period – The probation period when no vesting proceeds; vesting accumulates throughout this time, but the whole impact of the vesting is recognized immediately after the cliff.

When to structure ESOP in startups?

Make employee equity distributions and establish an ESOP at some point in between pre-seed and early-stage venture capital stages. It is not required in employee benefits during a Pre-Seed stage, but it might be useful to double-check how many shares you would be giving away to initial recruits. During this period, entrepreneurs are engaged in momentum and are frequently too preoccupied for an ESOP. At the moment, top personnel should receive equity/options on an as-needed basis.

Seed rounds could be concluded without the need for such setups; the advantage is that seed investors partake in the dilution. During the first wave of outside funding, Angel or investment firms and larger investors will demand an ESOP.

ESOP must be created with the first real VC round. Investors will expect them to be in place. Large equity awards will be sought by new recruits. The ESOP is essential to placate investors while also serving as a benchmark for the size of new-hire option awards.

How much equity should startups allocate in ESOP?

There aren’t any strict guidelines on how much equity you should set aside for ESOP, but you can begin to evaluate by simply examining your company’s founders, industry, regional emphasis, and hiring requirements.

Non-founder workers typically receive 15-20% of the firm, with some corporations giving up to 25%, with a modern trend towards larger portions. When workers get 15-20% ownership, the founders take on functional duties as senior executives and appoint others to fill critical technical or administrative jobs. When non-founder workers receive 25% shares, the founders aren’t really senior executives in the company or they plan to stand down. The majority of the staffing needs with such allocation are for engineering, developmental, or technical employees.

Strategies to setup ESOP

Here are the stages to comprehending, establishing, and implementing an Employee stock option plans that are appropriate for your business:

Strategies to setup ESOP

  • Discuss with experts and get good advice – Although the employee stock option plan principle is simple, there are several variants in the setup process, such as leverage vs. no leverage financing, share sale timetable, C company versus S corporation election, and so on. It is essential to know which mix of choices is appropriate for your specific scenario. Obtaining expert counsel will save effort, and money, and culminate in the proper plan structure.
  • Consider meeting requirements to allocate ESOP – Although they operate effectively with a wide range of shareholder liquidity conditions, some basic standards must be met in order to qualify. If the answer to most of the following questions are yes, your company might qualify for ESOP allocation:
    • Is one or more stakeholders interested in selling all or portion of their preferred equity now or in the coming five years?
    • Is your organization more than ten people?
    • Do your average pretax earnings exceed $200,000?
    • Is your business an S– or C- corporation?
    • Is your company in a field apart from professional services (doctors, dentists, and lawyers)?
    • Is your business profitable?
    • Is your overall earnings larger than $1 million?
  • Understand and prepare ESOP structure – They provide business owners with a tax-efficient way to dispose of all or portion of their ownership holdings on a timetable of their choice, or they allow businesses to distribute additional shares to employees to encourage higher productivity. The most fundamental strategy involves valuation, establishing ESOP trust, and leveraging it.
  • Understand benefits and pitfalls – These employee benefits have great advantages for both companies and their employees. However, startup founders must understand and weigh the benefits and disadvantages, as discussed above.
  • Compare change of ownership for all employees – When compared to alternative choices for changing firm ownership, the adaptability of employee stock option plan structures makes them more suitable for a diverse variety of changing business owner actions.
  • Get 409a valuation from experts – The following stage is to do a 409a business valuation. If the price of the business is too low, the owner might not be able to sell share options. Valuation could help businesses decide how to allocate company shares to the employees and what percentage of company shares can be issued through ESOP.
  • Prepare documentation – While an Employee stock option plan transaction is simple in terms of taxes, the required documentation to ensure these tax benefits is very sophisticated. Because of this intricacy, it is prudent for your firm to employ a consultant.
  • Start granting ESOP – Every time you intend to give options, request the company’s responsible person to create a fresh set of documented board resolutions authorizing the issuance of options to a specific recipient or a set of beneficiaries.
  • Issue option certificate – You may provide individuals with their option certification once you have obtained back the signed and dated letter.
  • Update your cap table – Internally, the corporation should retain a cap table to register and record all options issued, vesting schedules, expiration dates, and exercise dates. Startups can profit from employing cap table management software, such as one provided by Eqvista, because their cap table will be immediately updated whenever the shares are issued.

How does ESOP play a vital role in the capital structure?

Employee Stock Option Plans have a favorable and substantial influence on businesses, and they are particularly important for startups. The primary reasons are that entrepreneurs intend to keep their staff for a longer amount of time and cannot afford to give large compensation packages to do so. As a result, they provide these benefits to high-performing employees so as to instill a feeling of ownership within them and ensure they work to enhance the company’s profits and performance. Furthermore, ESOPs allow for decreased staff turnover and candidate pool maintenance.

Get expert’s help with a 409a valuation to structure ESOP with Eqvista!

It might be difficult to distribute share ownership while still incorporating it in your 409A assessments. Eqvista, a well-known 409A valuation company, can supply you with the most reliable value reports. Eqvista is a worldwide recognized expert in providing defensible 409A appraisals for businesses of all sizes and across all industries. The organization is NACVA-accredited and employs a team of highly trained specialists with the appropriate credentials, competence, and experience to offer you the finest service possible. When creating an ESOP for your startup, use Eqvista’s 409a valuation services.

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