Employee Share Option Plans – or ESOPs – have become an increasingly popular tool for businesses to reward and incentivise employees. However, we believe the concept is still not well implemented and many businesses do not maximise the use of ESOPs. Additionally, there are many entrepreneurs that remain overly protective of equity.

If incorporated properly, an employee share option plan is an effective way to retain employees invested over the long-term, and align interests for better value creation. There is a lot to unpack here for both the issuer of the plan as well as the employees, so let’s dig deeper into why it may be a good idea to share equity in your business and how start-ups can use ESOPs to attract the best talent.

The Benefits of ESOPs

Cash is often a sensitive issue for start-ups, and many early-stage businesses struggle to compete with attracting talent and remaining competitive in the market. As such, offering equity is a novel way to offer a competitive offer to talent. Offering company ownership is an appealing proposition and should be viewed as an additional mechanism to reward performance and loyalty beyond the traditional salary package.

Employees should think of it this way: ‘if the value of the company increases and I can contribute to that, so does the value of my equity’. They also effectively become co-owners, meaning they’ll invest and engage more in the company as they now have a professional and personal interest. The interests of company owners and employees are aligned. As the company valuation increases, so does the “paper value” of the ESOP.

Companies can use ESOPs to reward employees that are loyal or perform above expectations. It provides recognition and is also a practical approach to compensation.

Furthermore, an IPO or other exit event will provide employees with liquidity to realise part or all of their interest.

Business owners can take advantage of this system and therefore attract talent but also experience better retention and less staff turnover. Offering employees a potential means to make profits besides a regular salary can be a way to excite them to look for long-term value over short-term salary.

The Risks

Depending on the situation, ESOPs can be a more expensive asset to offer compared to cash incentives. Giving away ownership in the business will dilute founding shareholders, and if the valuation of a company increases dramatically, a few percentage points can turn into millions.

There is also an administrative burden as well as legal costs associated with the implementation and maintenance of the plan. In addition, if a company fails to structure its plan correctly due to lack of professional advice or incorrect advice given, there may be future implications for both founders and employees. There are ways to mitigate this which we’ll talk about a little later.

Even the most carefully orchestrated option plan carries risks. There is the risk that employees leave; and if options have already vested that means that the ownership of the stock, in a way, also departs the business. Simple mistakes can be a hurdle in bringing on investors later down the line.

One way to circumvent this is to create an appropriate vesting schedule. It determines when and how much the employee gets throughout their employment. The employee can receive the vested portion of their shares once they leave, but the rest forfeits to the company. More on that in the following section.

Useful Tips

Once you have decided that you want to implement an employee option plan, there are few ways to get started.

The Australian Taxation Office (ATO) has a set of standard templates available for free download which serve as a good starting point for many businesses. You can view the document catalogue here. Be prepared that further legal advice may be needed to fully implement the plan.

Another option is to go straight to a legal professional, but be aware of costs as hourly rates can add up quickly. Companies like Sprintlaw or Legal Vision provide Australian businesses with cost-effective and high-quality legal services through an innovative model.

In many cases, the Shareholders Agreement will be the principal source of regulation for Shareholders (other than the Constitution). Often the Shareholders Agreement will be drafted to take precedence over the terms of the Constitution and will govern the process of issuing and implementing the option plan.

Once the documents are set up, it is time to implement the plan and assign equity to the various employees, board members or advisors. Implementing the plan requires careful planning as there is a limit to the option pool, and you need to be mindful of the distribution to ensure you don’t deplete too early. On the other hand, founders need to ensure they don’t “waste” any equity by giving away ownership too liberally. It can be a fine balancing act, depending on the complexity of your business and team.

It is also important to consider the right vesting conditions to tie some obligation of performance or time to the Options. This will allow you to mitigate the risk of employees leaving the business. Determining the right vesting conditions will turn your ESOP into a powerful tool for incentivising your team to stay longer and work smarter towards the ultimate success of the company.

The plan should not only include employees but can also extend to board members and external advisors. This is very important. Incentivising board members through the issuance of equity is a clever way to align interests whilst ensuring that fees remain at a minimum.

Post implementation, there are providers like Cake Equity which have developed a program that allows you to manage your capital table seamlessly. The Cake program is a very efficient cloud-based and easy-to-use equity management platform.

Final Thoughts

It is our view that an ESOP is a powerful tool to align interest across the entire spectrum of the business, and as such, should be considered by most start-ups. There is a higher chance of engaging and retaining employees if they have a direct investment in the business.

The entrepreneur needs to manage the entire capital table including the option pool and determine how it can be used for strategic advantage; and ask oneself, ‘How can we ensure it is deployed intelligently to attract talent inside the organisation, on the board and for strategic external advisors?’.

We believe that the benefits outweigh the risks, although it is very important to carefully plan and structure the program. Lastly, it is important to set the option price and company valuation correctly, as setting the price too high or at the current share price means that new employees would only benefit if the company valuation increases. This may or may not work for certain companies.

If you have any questions about how to take advantage of ESOPs or other employee retention tools, please do not be afraid to drop us a note. As part of our Virtual CFO Program we assist our clients in planning, implementing and structuring their ESOPs in a commercially intelligent way.