From our previous articles, you should already know how to structure an ESOP in your startup to make it friendly to future investment rounds and dream exits. You should also be aware what kind of ESOP models exist and what are its consequences for the company and its corporate governance. In this article, we will explain how to engage your employees in the company’s management through an ESOP.
So without further ado, let's dive even deeper into all the essential aspects that startup founders should consider when structuring their ESOP strategy!
How to communicate an ESOP to employees?
As a startup founder, the first thing that you should consider, no matter what kind of ESOP model you choose, is to ensure that your employees believe the amount of stock they are granted can significantly improve their financial prospects and that they feel and act as shareholders of the company.
In order to make sure that your employees understand the true benefit of the ESOP, it is imperative that you openly communicate what ownership of stock in the company entails. You should clearly state how the ESOP works, what are the potential financial benefit of their participation in the ESOP, the tax implications, and the impact on corporate governance.
Employees should understand the real value of their engagement in the company, not only by owning stock but also on a managerial level. Therefore, planning and implementing more effective financial processes in the company might be an additional value, as ESOP participants should feel and be confident that you are making everything you can to increase the value of the ESOP.
Structuring the needs of your company and employees
The main goal of an ESOP is to either attract new employees or retain the current ones. To achieve this goal, consideration should be given to which employees receive the stock straight away, which ones may be granted an option to receive shares at a future date, and which ones are granted phantom shares (mentioned below).
Talk to your employees, listen to their needs, and create a path for their success, as you might only have one chance to keep them in the company… and you don’t want to miss it! After all, they need to know what it means to be owners and why they should trust you and your ESOP. In order to develop your employees and ensure they have the key skills necessary to advance and fill more senior managerial roles in an organization, you should be prepared to invest in their growth through training.
ESOP’s impact on corporate governance
Choosing the right ESOP program is a key matter to determine at the outset. You should seek to make the incorporation and the administration of the ESOP as easy as possible (i.e. from a corporate legal perspective).
Granting shares
If a certain group of employees receives stock in your company, they will become the shareholders and potential partners in your future ventures. Consequently, those employees will obtain all the rights of minority shareholders, which include the following:
- attending and voting at the shareholders' meeting;
- convening an extraordinary meeting of shareholders and putting certain matters on the agenda for the meeting;
- appointing directors/Management Board members and receiving dividends (if applicable);
- inspecting the company’s documents and books;
- preparing a balance sheet for their own use; and/or
- requesting the court to appoint an auditor to examine the accounting and operations of the company. The auditor’s opinion may be the basis for assessing the reliability of the management board’s conduct of the company's affairs. Employees granted with such rights should be entitled to see all the information about the company that enables them to understand and assess the company’s financials, where profits come from and how they affect the value of the stock.
Granting options or phantom shares.
If you decide to implement an option-based ESOP model, those rights (mentioned above) will only be acquired when beneficiaries are awarded real shares. The beneficiaries of phantom shares will not receive any shareholder rights or obligations, but rather a cash equivalent. Therefore, in a phantom share based model, the primary motivating factor for employees is financial.
Disposal of ESOP stock
Employees should be informed of various restrictions and rights that may apply to their stock. For example:
- they might not be allowed to sell the stock before the expiry of a certain period of time (i.e. a “lock-up” period);
- prior to selling their stock to a third party, they may be required to offer the stock to the current shareholders on the same terms (i.e. a “right of first refusal”);
- they are likely to be subject to a “drag-along” mechanism (i.e. which gives the majority shareholders a right to “force” ESOP beneficiaries to sell their stock together with the majority shareholders); and
- they may have the benefit of a “tag-along” right (i.e. to join the transaction of selling the majority stake).
Benefits of an ESOP
Creating an effective ownership culture in a company is a time-consuming and difficult process. However, with the assistance of an experienced management team and qualified external advisors, you are likely to create a favorable ESOP environment that will attract and retain employees. Upon implementing a successful ESOP, there is a greater probability that you will observe the company’s growth through organizational development and the transformation of your the employees’ approach (which may result in faster corporate growth and, ultimately, improving the long term financial position of your company).
Related Posts:
ESOP For Startups: How To Structure ESOP For Your Startup Future Funding Rounds? (by Magdalena Zawiślak, Associate, B2RLaw)
ESOP For Startups: Which ESOP Model Should Your Startup Choose? (by Dorota Gajuk, Associate, B2RLaw)
ESOP For Startups: Silicon Valley Standards And CEE Realities (by Teresa Pilecka, Senior Associate, B2RLaw)
