The last article in our ESOP series outlined the differences between the three, most common types of awards that can be granted under an ESOP. We also covered all the relevant definitions, details behind different ESOP models, as well as shared tips on ESOP communication for employee inclusion. Now equipped with this information, we can dig deeper into the practical implications of using ESOP models.
ESOP: to whom, for what period, and in what amount should a company grant shares or options?
A frequent problem encountered by a company’s managers at the stage of constructing the ESOP revolves around the following questions: (i) who exactly should be granted with an award, (ii) what should be the amount of the granted awards, and (iii) what should be the period of acquisition of the rights to the awards.
The answers to these three key questions are crucial and will determine whether a given ESOP will fulfill its role and truly be a motivating factor for employees and coworkers to undertake work and develop in a given company.
Who should be granted an award – the catalog of participants of the ESOP
Companies are usually willing to offer awards under incentive programs to two main groups of employees or coworkers.
The first group is key personnel. With respect to young, growth companies, including start-ups, key personnel is defined as those employees or coworkers who have made a significant contribution to the company's development in the past, and have supported the founders in developing the business, and thereby an award is an incentive and a means of rewarding them for their commitment and time already devoted to the company's development.
It is also a common scenario that a young, growth company does not have sufficient and free resources to devote to remuneration, and the promise of an equity stake in the company can be attractive to those involved in its development.
With regards to more developed companies, ESOP awards will be granted mainly to key, highly skilled professionals who are very valuable to the company, and their possible leaving would be very undesirable. Companies facing a shortage of qualified staff, especially in new and fast-growing specializations, will also try to encourage professionals from the market to choose to work within their company. A reward in an incentive program may be a tempting additional element, in addition to remuneration, motivating them to start working with a particular company.
The second group, on the other hand, often consists of executives and managers, for whom companies sometimes create a separate program from ESOP, referred to as a Management Stock Option Plan (MSOP). It is often that such individuals, by virtue of their involvement in management and managerial activities at high levels, that are highly interested in gaining equity participation in the company and decision-making power also at an ownership level of the company.
The amount of the awards under the ESOP
In the process of setting the terms and conditions of the incentive program, it is important to determine the maximum number of awards that may be granted under the ESOP (option pool). It should be borne in mind that awards in the form of real shares or options (after the vesting period) will affect the capital structure of the company. Also, after the acquisition of the shares, the participants will be entitled to exercise all corporate rights typical for shareholders, including voting rights.
The above will have an impact on the dilution of the company's shareholder structure.
In the process of determining the option pool, potential future or planned transactions should be considered, especially those which will affect the capital structure of the company, such as investment rounds. At this point, it is recommended that the maximum acceptable level of dilution of current shareholders should be analyzed, taking into account potential future investment rounds or anti-dilution clauses which are already in force on the basis of current investments and shareholder agreements. It is important to note obligatory minimum requirements for making certain decisions in the company required under the applicable law or the regulation of the articles of association of the relevant company reserving decisions in some matters for the benefit of the founders and key shareholders of the company.
However, with respect to awards in the form of Phantom Shares, i.e. those that do not affect the actual shareholding structure of the company, the determination of the scope of awards to be granted under the ESOP will depend on the values forming the basis for calculating the cash equivalent associated with this award. In the event that such cash equivalent is calculated on the basis of the company's financial results, such as revenue, turnover, or EBITDA, it is worth bearing in mind the precise methods of calculating the cash equivalent and establishing such metrics that will not adversely affect the company's liquidity in the future. It should be emphasized that an ESOP in this form will constitute a cash liability of the company, which will also affect its valuation in potential subsequent investment rounds.
How long should the vesting period be?
The acquisition of awards and the right to exercise awards granted under the ESOP is often conditioned by a lapse of a vesting period. The length of the vesting period should be balanced, taking into account, on the one hand, the desire to retain the participant in the company and, on the other hand, the actual delivery of the award and the achievement of the incentive objective. With this in mind, it can be assumed that a vesting period that is too long delays the realization of the award, so that many program participants may not be properly motivated and may even sometimes become increasingly demotivated giving rise to a desire to change job.
With regards to incentive programs aimed at motivating professionals to start or continue working for a particular company - the vesting period should be similar to that of companies competing for employees.
On the contrary, with respect to rewards directed to individuals who have already contributed to the company's development, a shorter vesting period may be considered. In doing so, the company would express its satisfaction with the cooperation with the individual employee or coworker and, at the same time, distinguish the manner and conditions of incentive awards for permanent staff from those for a new group of employees just starting to work with the company.
Companies that want to retain employees for a very long period sometimes choose to run several rounds of incentive programs, with the same or different types of rewards, in order to motivate employees and induce a desire for a longer relationship.
***
As you can see from the above, the three key issues that need to be considered when determining an incentive program depend on a number of factors, including, above all, the type of company's business and the objective of the program. In the process of preparing the program, it is also worth talking to your colleagues and key staff to understand what needs are most important from an incentivized perspective and which ones will realistically motivate the team.
The article was co-authored by Aleksandra Polak, Partner @B2RLaw
Related Posts:
ESOP for Startups: Shares, Options Or Cash Equivalent? (by Joanna Markowicz, Partner, B2RLaw)
ESOP for Startups: How To Structure ESOP For Employee Inclusion And Access To Information? (by Krystyna Jakubowska, Associate/Advocate, B2RLaw)
ESOP For Startups: How To Structure ESOP For Your Startup Future Funding Rounds? (by Magdalena Zawiślak, Associate, B2RLaw)
