Note: This post is meant to introduce the idea of ESOP and should not be taken as a definitive guide! Our suggestion is to consult with your lawyers before implementation.
Table of Contents:
- Why do startups need employee share ownership and what is ESOP?
- Examples from the real world and typical parameters
- How to add employee share ownership in Ledgy
1. What Is Employee Share Ownership and Why Do Startups Need It?
It’s no secret that the current entrepreneurial world is dominated by startup giants from the United States. Startups in the US have recognized that the competition for talent is heating up, high-value exits are more common, and talented people want a piece of the pie.
As a result, many US startups offer company shares to their employees in order to entice talented individuals to pick them over the competition. This is also the reason why, despite having limited amounts of cash, Silicon Valley startups attract the world’s best talent.
These startups consequently have the best employees to help the company succeed.
If European startups want to both catch up, and to stop losing talent to US companies, they have to start offering company shares to employees.
At its core, employee share ownership is employees holding shares of the company they work for. The most common employee ownership plan is ESOP or Employee Stock Option Plan. (What's the difference between ESOP and PSOP?)
With ESOP, the employer allocates a certain percentage of the company’s shares to eligible employees (usually full-time employees). The amount allocated can be based on the salary scale or length of service or something else. Regardless of the terms, it’s recommended to have a transparent and fair structure. On top of that, the founders have to decide if they want to allocate shares, options or phantom options. Below is a comparison table which can help you decide.
The allocated shares are held in an ESOP pool (called trust in the U.S., or conditional capital in Switzerland) until the employee retires or leaves the company. The shares from the ESOP must vest before the employees can receive them.
A vesting schedule refers to a period of time before shares are unconditionally owned by an employee. The vesting schedule usually has 2 defining parameters: a cliff, and a vesting period. A cliff means that no options are vested during the cliff period (1 year is common), and a vesting period is the time it will take for the asset to be completely owned by the employee.
For example, 4 years vesting period with a 1-year cliff, means the first 25% of the equity vests at the end of the first full year and the rest of the grant (75%) will vest over the remainder of the vesting schedule (in this case 3 years). If the employee leaves before the first full year, he will not own any shares.
In recent years, new vesting plans have emerged. One of them is back loaded vesting where the employee gets 10% in the first year, 20% in second, 30% in the third and 40% in the fourth. Another plan is performance-based vesting, which means employees are only given stock options if they reach certain targets.
When an employee wants to exercise her ESOP options, she first has to purchase them for a strike price. The strike price is a fixed price the employee must pay to buy each option, and is typically a discounted version of the stock at the time of hire. In the future, the employee can sell her shares and if they’re trading higher than the strike price, she has the potential to make a lot of money.
For example, an employee has the option to buy 1000 shares at €10. If she sells them 3 months after the company’s IPO, when the share price is at €50, with her €10,000 investment, she ends up with €50,000.
In Silicon Valley, companies have been awarding company shares for more than 30 years. As a result, there is a lot of data available for younger startups to look at and determine which employee compensation plan fits best.
The European startups, on the other hand, have to rely on their founders' willingness to go off the beaten path and research or even create their own plans.
If you’re involved with European startups, read the next section, where we discuss both what we found while researching existing data, as well as how our users, at Ledgy, typically design their employee share ownership plans.
2. Examples from the Real World and Typical Parameters
A typical ESOP size
In the U.S in the seed round the typical ESOP represents 10% of the company’ total shares, although the new recommendation from Y Combinator and The Family is 20%. The size is also very dependent on the composition of the founding team. For example, if you need key hires or a non-founding CTO, you’ll need to allocate more shares to the ESOP.
In Europe the typical ESOP is 10% and it doesn’t increase (but also doesn’t get diluted) with subsequent rounds. In the U.S. however, it rises to 20% or even 25% by series D.
Index ventures projects a change in how European startups implement ESOPs. On average ESOP size for future generations in Europe will be 12% in series A, 14% in Series B and 16% in Series C.
The vesting schedule is determined in each ESOP differently. The most common plan has a 1 year cliff with a 4 year vesting period.
In the picture below we can see Ledgy users’ most common vesting schedules.
Ledgy users mainly choose a 4 year vesting plan. Additionally, out of all employee pools, 82% of employees were awarded options while the other 18% were awarded phantom options.
Among the Swiss Ledgy users, the most common is a 4 year vesting plan (66%). Furthermore, among all companies that implemented employee share ownership, more than 75% of them allocated options and the rest allocated phantom options.
The most popular vesting schedule in Switzerland is a 4 year vesting plan, vesting every month and with either a 6 month or a 1 year cliff.
In Germany the most popular vesting plan is, again, the 4 year plan, vesting every month but either no cliff or 1 year cliff. Phantom options are most common in Germany.