3 Key Things To Consider When Setting Up an ESOP
- The exercise price is the price at which the ESOP holder has the right to purchase vested options within the term period. This is also known as strike price or grant price.
- A low exercise price tends to be financially beneficial to ESOP holders and make ESOP more attractive to employees.
- An employee’s seniority, job function, length of service, and performance are deciding factors for how much ESOP to issue
- Balancing the needs of the company’s founding team, employees, and investors is crucial in determining the size of the ESOP pool.
Are you a founder who’s looking to attract the best people to build your startup? If so, offering an Employee Stock Option Plan (ESOP) should be top of mind. We recently published an article on how ESOP can benefit companies.
If you’re new to ESOP or need a quick refresher, you can check out our simple guide here!
With an increasing number of companies taking an interest in ESOP across Southeast Asia, here are three key factors that founders should consider when setting up an ESOP.
1. Setting the Exercise Price of Your ESOP
The exercise price per share option is how much employees must pay for each option if they wish to exercise their vested options within the term period. It is also known as strike price or grant price.
What is the best way to determine the exercise price?
For some, the exercise price is usually determined by the latest fundraising valuation (i.e the price per share of the last financing round). For some, especially in Southeast Asia, companies are choosing to go with a nominal amount for the exercise price.
There are many benefits to having a nominal exercise price.
First, a low strike price makes exercising the stock options more straightforward and less burdensome (financially) for all ESOP holders.
Second, a low exercise price makes a company’s ESOP – and overall compensation package – more competitive. This is especially crucial for early-stage startups, where talent attraction and retention are key.
Third, a low exercise price maximizes the financial upside for all stakeholders. During a liquidity event, the ESOP holder will reap the difference between the share price and the exercise price. Therefore, a low exercise price means a greater financial return.
As a founder, you may be wondering if you should change the strike price as your startup grows and secures more funding. We do not recommend this, as amending the strike price after each funding round adds complexity and makes it harder for employees to see the value of their ESOP. Instead, founders can explore issuing ESOP on a tiered basis, which brings us to our next point.
2. Deciding on the ESOP allocation
Besides determining the strike price, founders must consider how best to allocate the limited ESOP pool across different employees.
Founders should consider the employee’s seniority, job function, length of service, and past performance when allocating ESOP. The stage of the company is another key factor.
Let’s illustrate how the stage of the company affects ESOP allocation with an example. Company A has just raised seed funding and is looking to hire a General Manager. To attract the right candidate, ESOP (10,000 stock options, each share valued at $1, total value of $10,000) is offered.
Company A continues to grow and closes its Series B funding in a few years’ time. By then, let’s assume that the value of the company has grown five times. If Company A were to hire another General Manager post-Series B funding, it will only need to offer 2,000 stock options (each share valued at $5, total value of $10,000) to match the compensation package for the same role.
In parallel, founders also need to strike a careful balance between the interests of all stakeholders. You want to ensure that you allocate ample ESOP to your employees, to keep them happy and motivated to do good work. However, if you allocate too much to your employees, you run the risk of diluting your stake, as well as your investors’ stake. This can potentially compromise your position in the company.
It is critical to balance the needs of the company’s founding team, employees, and investors when allocating ESOP.
3. Determining the size of the ESOP pool
A typical ESOP pool is about 10-15% of the company’s total number of shares, on a fully diluted basis. As the company grows and raises more funds, the ESOP pool grows as well.
Founders can use the increased ESOP pool to increase their staff strength, as well as offer more stock options to their high-performing employees.
For example, Company B, a Singapore-based company, sets aside 10% of the company’s total shares as the ESOP pool. Assuming that Company B has 8 million shares on a fully diluted basis*, this means that the ESOP pool will contain 800,000 shares.
*Take note that only 7.2 million shares will be reflected in the company’s ACRA (Accounting and Corporate Regulatory Authority) records. The 800,000 shares in the ESOP pool will not be reflected in the ACRA document.
An investor subsequently invests in the company. Let’s assume that post-funding, the company has a total of 10 million shares on a fully diluted basis. With 10% of total shares still allocated for ESOP, the ESOP pool increases to 1 million shares. The additional 200,000 stock options can be used to attract and retain talents.
While the ESOP pool grows with each round of funding, the shareholding of founders will get diluted.
As a founder, you want to ensure that there is sufficient ESOP to attract and retain talent. However, it is in your interest to ensure that the ESOP pool is not significantly larger than foreseeable hiring requirements. Otherwise, you will be giving away more of your company than you might want to.
Using ESOP to your advantage
ESOP is a powerful tool available to founders to attract and retain talent.
Setting the exercise price, deciding on the allocation of stock options, and determining the size of the ESOP pool are three areas that you want to get right at the start.
Our team at Svested would love to help you with that. At Svested, we supercharge growth, create wealth, and fulfil dreams through ESOP. Set up a discussion with us at email@example.com and allow us to be part of your startup journey.