Employees are one of the most important assets of every business. Accordingly, founders and investors have a vested interest in incentivizing employees to increase the value of the company. An ESOP is a method used to incentivize employees, as it gives an employee a part of the company (e.g. after 4 years of hard work).
Do minority shareholders constitute an attractive cap table for future investment rounds? Yes - VCs welcome ESOP shareholders and often require their portfolio companies to introduce an ESOP. However, they want to ensure that an ESOP is correctly implemented in order to prevent a situation where numerous corporate laws impede the company's operations. On the other hand, strategic investors often prefer to acquire 100% of a company and require assurances that ESOP shares will be transferred and that minority shareholders will not block the transaction.
In this article, we will explain how an ESOP in your company may be structured in a manner that is friendly to future investment rounds and dream exits. So, let’s discover the overview of most important steps that should be considered by startup founders!
Type of award
The first step to determine the structure of your ESOP is to figure out what type of award will be best for your team and business.
The incentives at your disposal range from options, phantom rights or shares – followed by the decision regarding the amount of the available option pool (i.e. the piece of the pie / company you want to offer to others). While each has its respective pros and cons, it is usually the founders to decide which one is most suitable – whether they want to (1) give shares to their employees straight away, (2) provide their employees with an option to receive shares at a future date, or (3) grant their employees with “phantom shares” which provide the employees with the same economic interest of a share in the company albeit without any corporate rights that a shareholder would have a law.
With each type of incentive, care should be taken to ensure it is viable protects you and your company. While you are not strictly required to implement any safeguards, and even if you don’t think this is important, it actually looks good for investors!
Consider KPIs
A good practice for a company considering investment rounds (and a subsequent exit) is to link the vesting of shares with particular corporate milestones (e.g. an investment round closing or the company’s valuation). However, if you are unsure about how your company may progress, you don’t have to create hard rules straight away. Choose two and then give yourself an option to add more via a management board resolution. After two years, you will be more likely to know the direction of your business.
Remember that the ESOP Terms and Conditions is simply an agreement that may be changed at anytime. However, changes would require the consent of every participant and it may not be perceived positively to “change the rules during the game”. Transparency from the outset would be ideal - explain to your employees how certain targets may impact the amount of award…it is a motivational boost so it has to be realistic.
Founders often elect to include an IPO as one KPI – the grand finale. Here you have to decide whether the ESOP continues or stops. Shares may become stocks or you can make all necessary settlements and start a new chapter.
Structure Corporate rights
Every business is different and, regardless of the legal form of your company, our ESOP legislation (or rather a lack thereof) provides you with the freedom of contract. However, this does not mean that an ESOP structure should not be contemplated from the very beginning. There are certain corporate mechanisms you should apply straight away to avoid problems down the road.
Firstly, minority shareholders should not be allowed to block further investment rounds via a share capital increase. When founders lose entire control over the company it is important to ensure that voting thresholds for adopting resolutions are clearly defined in the company’s Articles of Association (i.e. to prevent ESOP shareholders from blocking the adoption of such resolutions).
Secondly, it would be prudent for founders to impose a “drag-along right” (whether in the company’s Articles of Association or a Shareholders Agreement). Such a right would enable founders and/or investors to force minority shareholders to sell all of their shares to a bona fide third party that wants to acquire the company. You should not expect that a shareholder forced to make a statement about the sale of their shares will always be happy to do so. Therefore, lawyers often advise their clients to secure these types of tentative declarations of intent with an irrevocable power of attorney early in the ESOP participation agreement. Investors often prefer to not negotiate with a large number of shareholders and require the comfort of knowing that minority shareholders will sell on the same terms (and at the same time) with no unexpected problems arising.
Finally, ESOP shareholders are often provided with a “tag along right” during an exit. Such a right means that when the founders (or a majority investor) decide to leave the company – participants can “tag along” and sell their vested shares.
It’s worth remembering that ESOP shareholders are effectively linked to the company’s value/assets and not so much to company management. So, we rarely put any ROFR in ESOP participation agreements.
Cashless settlement
It’s always better not to pay from your pocket - the same is true for an ESOP. After the shares have vested, there will be time to settle the ESOP. ESOP shareholders often buy their shares for e.g. a nominal value. Therefore, the best option is to make somebody else pay – for example – an investor during another round. This cashless settlement (from a lawyer’s perspective) can also be done in various ways, for example through a transfer of a claim for ESOP shares (assignment of claims) to an investor.
Best option for ESOP structure
ESOPs may be implemented in numerous ways and tailored to your corporate needs. We strongly advise that such matters are carefully considered at the beginning – the kind of award (one or more), the timing, the KPIs and also the possible investment round, exit or IPO. It would be prudent to ensure that your ESOP terms and conditions and ESOP participation agreement are relatively general and do not restrict you from exercising your corporate rights in the company or block you from making key investment decisions. Investors want to see a structured organization with certain mechanisms and rights. Introducing an ESOP into a company is a well-regarded practice in terms of the future investment rounds.
Related Posts:
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)
ESOP For Startups: What is ESOP and how does it benefit startup? (by Marcin Laczynski, Partner, Next Road Ventures)
