The Fundamentals of Employee Stock Options

Talent supply cannot match rapidly increasing demand, pushing ventures to seek alternative solutions to acquire and retain talent. (1) Negative impact of CV-19 on employee attrition, (2) increasing number of startups each year hunting for new talent, (3) consolidation of tech companies turning into capital-rich giants with competitive offers, and (4) increasing tech-related talent need of non-tech enterprises are some of the root causes addressing the need for alternative solutions to remain competitive. This is where ESOP steps in as a fundamental tool for founders. But, what is ESOP? Why is that important to founders? And, how can one build a robust ESOP?

What is an Employee Stock Option Plan?

In a nutshell, employee stock options are the type of equity granted to executives and employees as part of a compensation plan. The plan created by the founding team that reflects the conditional equity allocation for each individual is called ESOP (some refer to that abbreviation for the consolidated plan for all employees as well). There are several typical characteristics of an ESOP (may vary based on various geographies). Here is a short list;

• ESOs can have vesting schedules that restrict the ability to exercise the allocated equity. This approach reinforces employee retention by having a one-year cliff (no equity allocation for a full working year) and four-years of monthly vesting.   
• ESOs are taxed at exercise, and stockholders will be taxed if they sell their shares. Regulations around taxes may vary and should be clearly communicated to employees.
• Founders usually create an option pool when there is a liquidation event for future hires. We will be covering the size of the pool in the following section.

As Silicon Valley has a thirty-year history and is home to many sophisticated success stories, employee stock option planning has become almost standard. There are several proven good reasons for favoring the approach;

• Employees are more motivated to over-perform with the nurtured sense of belonging
• The company can enjoy liquidity and tax benefits of having such plans
• Offering a vesting schedule helps founders to retain key employees in the long-run
• Founders can have the flexibility to negotiate and act bullish to hire the best talent

Despite the benefits, founders typically struggle with identifying the right equity percentage that addresses short-term needs while securing long-term benefits. But, what should be the ideal option pool size? 

How much option pool should founders allocate?  

In the US, ESOPs are typically increased from 10% at seed to 15% at Series A. The ESOP then grows with each funding round – reaching up to 20%, or even 25% by Series D. In the EU, seed ESOPs are usually set at 10% and flattens in future rounds. On average, EU employees end up with half as much ownership in later stages compared to their US counterparts.

And to decide the size of the option pool, founders need to focus on the hiring plan instead of blindly adopting global practices. By doing that, make sure the ESOP allocation is sufficient; if over-allocation occurs, founders risk diluting their stakes along with the existing investors. (Below, you’ll see the example of the ESOP evolution of an XCo.)

After determining the allocation of the option pool, the other question is identifying the right equity percentage for potential hires. So, let’s dive into it by looking at generally accepted approaches.

How can founders identify the right equity grant for a potential hire?

The frequently asked question from the founders does not have a one-size-fits-all answer. There needs to be a synthesis of multiple approaches to draw a practical conclusion aligned with the context. Here is an overview of the available approaches as a starting point;

1. Equity Equation: Founded by Paul Graham, the grant is calculated via valuation estimate and value impact of the employee. (Below, check the details of equity equation)

2. Market Benchmarking: Based on employee seniority and job family, the grant is calculated by market benchmarking. Here is a good tool provided by Index Ventures. (Below, check the details of market benchmarking.)

After all the inputs we gather, founders can check out the following steps to plan the equity grants for near-term hires until Series B;

1. Create a diligent hiring plan for the next 18 to 24 months – this is a must

• Equity is the most valuable asset; use them wisely
• Try not to hire for the sake of hiring to please investors
• Build a realistic time-based plan to optimize your liquidity

2. Estimate how much equity you anticipate needing for each new hire

• Start planning with senior hires, as their grants will likely be the largest
• Include a buffer for negotiation, be bullish if necessary
• Update the hiring plan after settling each grant for each hire

3. Determine appropriate grant size when making an offer based on; 

• Amount of allocated and unallocated employee option pool 
• Role or experience of the individual
• Market practices or competitor offers

You can check out the roadmap below for the XCo example to have an idea about what a roadmap may look like (we did not include time-based plans for the sake of simplicity). 

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Last but maybe the most important aspect is the way of communicating the equity grants as part of the compensation plan during offers. Founders need to provide clear information about the number of shares, target valuation, vesting schedule, tax payments, and performance-linked grants to the potential hires. Otherwise, all the beautiful craftsmanship may become redundant due to a lack of informed decision-making of the potential hire. And this wastes resources (additional acquisition cost, loss of time, diminished growth due to the attrition of the key employees)

Please reach out for your additional questions or other topics of interest. Hope you enjoyed the content. Stay tuned for more.