A well-construed share option plan which is also well implemented in the company is one of the best methods not only for keeping the best employees at the company, but also for attracting new ones from the market, and not necessarily by means of top salary.
Option plan, option pool, ESOP*, MSOP, options.
A topic which is incredibly important for startups in the entire world, whether they are new undertakings or titans of the industry. On the one hand, it stirs the imagination since many millionaires among Google employees are in fact beneficiaries of option plans, on the other hand it is a significant element of investment and employee negotiations.
In Polish startups the topic has been so far treated very inexpertly and with much simplification. More often than not, the issue of ESOP is incomprehensible and ignored by startups’ founders, investors, as well as the employees themselves. Of course, it happens to be included in agreements, sometimes there are some regulations or participation agreements, but as a matter of fact the topic is just budding.
Still there are some exceptions—startups which from the very beginning treat the issue of option plan very seriously, and the plan itself is well-prepared, thought-out, legible and thoroughly implemented. In this article I’ll try to introduce you to the issue of option plan and convince you to plan and implement them well.
*ESOP – Employee Stock Option Plan
What is it exactly?
In very simple terms, an option plan is a mean to include employees in the group of co-owners of a company, that is, practically, to give them a chance to share success of the business—to which they also contribute. If its structure is well thought-out and the company is successful, the employees and associates covered by the plan will also derive financial benefit from such success. Simple in theory but, as always, the devil is in the detail. And not necessarily that connected with the very construction of the plan.
The biggest fault of many option plans in Polish startups is an ill-considered manner in which they are communicated to employees. Unfortunately, this results usually from an even more basic problem—the plan itself is ill-considered. It is a product of a fashion, hype, and in most cases has unclear rules. I know numerous founders who have an option plan prescribed in their investment agreement but have no clue what to do with such a provision. What makes the issue even more complicated is that most startups are limited liability companies, read more below.
There are some exceptions to this general remark and probably the best example is an option plan at Joymile (a startup of Tomek Kraus and Wojtek Frycz, designed to facilitate easy purchase of a second-hand car and enhance security of such transaction), where the concept of the plan had been primarily adopted by the founders even before they established the company. Upon its establishment some mechanism were anticipated to enable its implementation, and the fully though-out, well-considered, long-term and flexible plan was implemented even before the seed round. What is most interesting and distinguishing among Polish startups is that the plan is comprehensive and includes EACH employee. When developing the plan, its founders had a clear vision of its objectives. They had also extensive knowledge on the structure of similar plans and even if not all assumptions may easily be translated into the structure of a joint-stock company, it was a pleasure to work with them.
Functions and features of option plans
A good option plan has several key features without which its implementation usually makes little sense. Its basic features include in the first place the objectives which it is to achieve from the point of view of the enterprise, managers and investors. Reward, motivation and building up loyalty of employees. And more often than not—also support in recruitment, an advantage communicated to potential employees as early as at the recruitment stage.
Not every employee can receive the same number of options. It is one of the most frequent topics discussed with founders planning option plans—how much can be given to particular persons. Usually they also demonstrate a very short-term approach. There are many possibilities, but so far the system implemented in Joymile appeals to me most, with the share pool available to an employee depending on 2 key factors: grade, that is whether you are a junior, senior, expert or manager, and the period of business development in which the employee joined the team. The employees from the “first 10” faced the biggest risk, trusting Tomek and Wojtek even before they obtained funding. The risk for subsequent 10 was already smaller, for the group of another 30 employees even smaller and so forth. All are subject to 4-year vesting calculated from the employment date. If an employee is promoted during the plan, his/her target pool is also proportionally adjusted. The entire system is very clear and predictable. What is more, the management board may to some extent modify the conditions, in particular for external experts whose relation with the company usually does not extend as much as 4 years.
A well-construed plan clearly demonstrates the features I mentioned above. The reward function is obvious. Loyalty of an employee is enhanced in connection with the vesting mechanism, but the very fact of being a co-owner makes him/her perceive the company as something more than just an employer. The value of options is connected with the company value and the latter is determined by the quality of work of each employee, therefore if we take care of good communication of those mechanisms, we will enhance motivation. When searching for new employees in the market, a good, specific and clear option plan presented as early as at the stage of negotiation of remuneration is a much greater benefit than a frequent claim “we are going to introduce an option plan but are still working on details”.
Types of option plans
Not only employees can be beneficiaries of option plans In the employment realities of young Polish companies it is clear that the form of relation with a given employee itself (e.g. a B2B contract) does not mean that such person is less important for the company, thus it is worth a while to construct the plan well so as it applies to associates as well. It can cover persons not permanently connected with the company, e.g. advisors (less often mentors, but usually I advise against procuring mentors for shares, but this is an issue for another article). Sometimes companies have 2 parallel plans in place—ESOP and MSOP (Management Stock Option Plan). I’ve also encountered solutions where company’s key partners and suppliers were covered with a certain type of option plan. If such solution has a clear business purpose which is long-term and can be well communicated and justified (e.g. to investors), it is worth a while to at least consider it.
Basic conditions and mechanisms in option plans
Option plans contain a range of criteria and mechanisms regulating when, how many and in which form a given employee will receive shares.
One of the most important criteria present in almost every plan is employment term—the time for which the employee works for the company. It may be a time for which the employee has to retain employment to be covered by the plan and a time for which the employee has to retain employment to receive shares, but also a time for which the employee is bound by certain restrictions connected with those shares. Below I discuss key criteria, not only those connected with time lapse.
VESTING, or a mechanism for gaining rights to options along with the lapse of employment time. Usually it is a period of 4 years with the so-called cliff, or annual periods after which the employee earns a part (25%) of the entitlements. Yet it is not a core principle and it happens that vesting is annual with a one-off cliff or the term covers 4 years with a quarterly or even monthly cliff.
Globally, “mature startups” more often than not use “back-end-loaded” vesting, which also includes a cliff but with the part of the target option package increasing in each following year. For instance, 10% in the first, 20% in the second, 30% in the third and 40% in the fourth year. Such scheme is even more effective in discouraging employees from leaving the company after a year or two.
LOCK-UP and other disposal restrictions. In the vast majority of cases the beneficiaries of an option plan are subject to at least the same restrictions in terms of disposal of shares (when exercising options) as the founders. They are not allowed to dispose of them before the lapse of a specified time, what is more in the case of an IPO (a stock-exchange debut) they also have to withhold sales for some time defined in the participation agreement or conditions of the plan. When joining the plan they also agree to a DRAG ALONG mechanism—the right to drag along, or force them to sell shares along with majority shareholders. In consideration they usually obtain a TAG ALONG right, i.e. the right to join a transaction of sales of a majority stake. Options themselves (or warrants in a joint-stock companies) are almost always non-transferable.
Right of first refusal. Upon the lapse of the term in which the foregoing restrictions apply, employees will still, before they are allowed to sell shares to a third person (other than a company’s shareholder), be obliged to offer such shares on the same conditions to the shareholders first, and in some cases when the agreement is appropriately constructed—the company itself.
Participation in an option plan does not guarantee employment. Hence the need to regulate the situation when the employee decides to leave the company. And there are so many possibilities.
Good Leaver. Positive as it may seem, typical “good leaver” situations, meant as an employee’s leaving the company, include, among other things, death or becoming incapable of working. They may also cover issues connected with moving company’s registered office to another city or country, or a situation when the employee is dismissed for reasons not directly resulting from his/her performance as an employee. If the employee takes the “good leaver” scenario, he/she does not lose previously obtained (vested) options, and sometimes receives additional bonuses (Accelerated Vesting), e.g. an automatic vesting of the right to a share for a period even longer than the actual work term (frequent in the case of death of an employee, in particular the one who e.g. worked for 2 out of 4 years prescribed in the plan).
Bad Leaver. The “bad leaver” scenario covers not only cases when the employee files a termination notice before the lapse of a predefined term (specified e.g. in the participation agreement), but in the first place cases of serious violations of law, acts to the detriment of the company, in particular undertaking a competitive activity and other material breaches of the agreement binding the relevant person with the employer. A typical sanction for a bad leaver is the loss of all options and sometimes also an obligation to resell (for the purpose of redemption) already acquired shares to the company.
The procedure for handling both situations should be described in a clear and understandable manner in the conditions of the ESOP or participation agreement.
Death of an employee is also usually regulated in the conditions and in most cases has a formula to protect the company against the effects of prolonging inheritance proceedings, but sometimes it brings employee’s heirs an additional benefit, as e.g. the accelerated vesting mentioned above.
Exercise price and exercise period. In ever more cases the employees do not receive shares “for free”, but have to pay for them, naturally a price which is considerably lower than the market value of the share applicable at that time. The exercise price may be determined in a fixed manner in the plan itself, but it also may vary from time to time along with subsequent plan implementation stages. Why an employee is expected to pay for the share entitlement even after working for 4 years? There are at least 2 reasons for that. In the case of companies entering the stock exchange, a generous option plan exercised at the nominal share price may be problematic from the point of view of investors (read more about dilution below). Also the psychological aspect is important—the employee exercising his/her options should “feel their value”—in the end he/she will benefit from it anyway. When the exercise price determined sometimes a few years earlier is lower than the current share value, the employee may decide not to exercise his/her options at all. Both in such case and due to financial capabilities of employees, what is of great importance is the exercise time, i.e. the time for which an entitled person may demand his/her options to be exercised, calculated from the time of vesting such entitlements. The longer the exercise time, the more flexible situation is faced by beneficiaries. On the other hand, thanks to a prolonged exercise time (even up to 10 years) the company is able to add next “motivators” to keep the job by reducing the exercise time to 2-3 months in the event of termination.
Equivalent. Instead of issuing shares, option plans frequently prescribe payment of a cash equivalent calculated on the basis of the current company value. Such measure is even recommended for limited liability companies, where exercising options may pose some problems, while it is also applied in joint-stock companies.
An option plan prior to establishment in limited liability and joint-stock companies
Ever more frequently I receive questions related to option plans from founders at a very early stage of their businesses. Even before a company is registered: in a time when they work as an informal project group, sometimes even before any founders’ or similar agreement is concluded. Does it make sense? Yes, and it is a good one. It allows founders to consciously consider the company’s structure or cap table and to clearly distinguish founders from employees and advisors at a very early stage, but also in a quite specific manner to present the offer to new employees or associates. Simple provisions related to an option plan may be included in a founders’ agreement (shareholders’ founding agreement) and then be transferred and elaborated in an investment agreement or simply implemented upon registration of the company.
Construction of an option plan in a limited liability company is yet another challenge. Due to its limitations (in particular the minimum share nominal value), creating flexible option plans is difficult, not only in formal terms but also simply with regard to calculation. There is also no “magic of big figures”—in a limited liability company, even if your capital covers 2,000 shares, a typical option package will range between 1 and 10 shares. In a joint-stock company with the same share capital we can have 10 million shares and the same packages as mentioned above as much as between 5,000 and 50,000 shares. Sounds better?
Joint-stock companies are the most convenient entity to implement option plans, not only thanks to “magic of figures”, but also due to purely formal possibilities. Issue of warrants, non-voting shares, by default a shorter way to share liquidity are just a few of them.
Option plan vs. investors
Investors’ approach to option plans may also be very divergent. Insofar as globally it is an obvious standard and investors regard ESOPs and option pools as something not only natural but also desired in a startup, in Poland many investors see only the fact that an ESOP will “dilute” them and fight to minimise it. It is a very shortsighted approach, and I am not the only one to believe so. Luckily, now I practically do not encounter such total resistance to option plans as I did 2-3 years ago. Aware and experienced investors do not mind an ESOP at all, what is more they also help the company to plan and implement it.
The mentioned dilution is a mathematic consequence of the issue of shares for the employees. Usually it is solidary—it dilutes all shareholders in the same proportion, and this is a good solution. In the case of “sensitive” non-experienced investors, it is much easier to swallow if the company/founders from the very beginning communicate the existence of a virtual “option pool” and when negotiating the investment, working for the cap table, consistently place there shares which do not exist at that time. It is also good to have the issue of share pool or shares which are to be acquired under the ESOP indicated in the founding agreement or shareholders’ agreement.
As was demonstrated, an ESOP or option pool is something more than a fashion and a cool option in our startup. It is also a powerful tool helpful in building up a company. It is worth a while to take a closer look at it, treat more seriously and do not fear “investor’s response” or problems with implementation. And if you communicate “options” to your colleagues in a young startup but you still have no plan—get down to work as disappointment about “pie in the sky” may be very hard.
