Remuneration of team members in the form of profit sharing is already standard in the startup world, representing an opportunity to recruit and keep key people in the team. There are various ways to implement an ESOP and they can be used already in the first stages of your startup.
1. Principles of ESOP
An ESOP means team members have the opportunity to participate in future proceeds accruing, e.g. from the profits of the startup or from its sale.
An ESOP can therefore significantly increase the team’s motivation as it makes the team members in a sense co-founders. It can help the founders in the early stages to attract those team members to whom they cannot yet offer a market-rate remuneration. Investors also appreciate the motivational effect of the ESOP and expect the startup to have it in place in the early stages or to implement it shortly after the investor enters the startup.
2. ESOP Conditions
For the ESOP motivational effect to work, participation in the ESOP is always linked to vesting. Vesting can be tied to:
- time – the most common vesting period used is a three to four-year vesting period with a one-year cliff, while before the end of the cliff period vesting does not run and after its end, a part of the shares corresponding to the cliff period is vested at once, while the remaining three years are vested monthly, quarterly or annually, depending on the preference of the founders. Thus, in four-year vesting with a one-year cliff, 25% of the target shares are vested after the first year and the remaining 75% are vested proportionally, e.g. on a monthly basis.
- KPIs – they are agreed upon in advance and once they are met within the agreed period, the vesting ends, i.e. the team member becomes entitled to a share or other agreed benefits (depending on the type of ESOP).
After the team member participating in the ESOP leaves the startup, their vesting stops and if the cliff has already passed, they typically keep part of the share they vested (i.e. if the person participating in the ESOP was to receive 1% after four years, they had a one-year cliff and left after two years, they keep 0.5% and depending on the agreement, for example, in the event of a future exit, they would be entitled to a portion of the profits that corresponds to 0.5%).
As investors primarily invest in a competent team, they expect the team to remain in the startup for some time. Therefore, vesting is often applied to the founders themselves as well. Typically, they are subject to reverse vesting, which should be differentiated from the ESOP for other team members, which we discuss in this article. Reverse vesting involves the loss of shares held by the founders at the time of the investor’s entry if they leave the company or cease to be active before the vesting period expires. This is the reverse of a traditional ESOP, where team members acquire shares gradually.
Typically, only certain key team members can participate in an ESOP, but we recommend involving as many members of your team as possible to boost motivation and the feeling that everyone has their skin in the game. If you work with advisors (e.g. former founders of successful startups), it’s also common to offer them participation in the ESOP as an (only) reward.
3. ESOP Size
Founders normally reserve 10% to 20% of shares for ESOPs. However, this does not mean that all percentages must be immediately allocated for vesting by the team members involved in the ESOP at the moment. On the contrary, this share typically also includes some reserve for a few years ahead (at least until the next investment round) for any other people who join the team in the future. In investment rounds, the size of the ESOP is subject to negotiation and will be determined in the investment documentation.
Key team members typically receive 1% to 5%, other senior team members around 1%, mid-level team members approx. 0.45% and juniors below 0.15%.
Investments in a startup typically also dilute the share that is intended for the ESOP, i.e. if a team member was supposed to receive 1% after four years, but an investor entered the startup during those four years, it is quite likely that the share in the proceeds will be less than 1%.
4. How to Implement ESOP
Overview of Basic Options
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If you are just starting, have an idea, haven’t formed a company yet (if you want to know how to do that, read here), or have only recently formed one and don’t have investors or customers, you can take the first step towards setting up an ESOP by preparing a “trust-me” sheet. In the sheet, you will state what percentage of the company’s share will be allocated to team members and you can also include your predictions for future valuation. This way, you can easily show your colleagues how you want to share in the future success of your startup. You may not give your team members much legal certainty, but you show your intention to further develop the ESOP.
If you’ve already formed a company, it is expensive and complex to give team members a real share in your startup. That is why most pre-Series B startups in the Czech Republic and Slovakia implement a so-called phantom ESOP. This method means concluding a contract between the founders, the startup and the team member, based on which the team member is entitled to remuneration in case the founder, thanks to owning a share in the startup, acquires some income, e.g. a share in the company’s profits or the purchase price resulting from the sale of this share (i.e. the team member doesn’t actually own the share, but it works as if they did because they participate in the agreed upon benefits resulting from the ownership of the share). The amount of remuneration will depend on the size of the team member’s vested share. As the team member doesn’t actually own a share in the company, they don’t have the right to vote at the General Meeting.
The vesting conditions will be set in the contract, and it provides the team member with much higher legal certainty than the “trust-me” sheet. However, a disadvantage is (as with the “trust me” sheet) that the income from the ESOP in this case would be taxed by the team member as income from employment or business activity.
A startup may enter into contracts with its team members based on which they acquire an option to purchase shares in the startup under pre-determined conditions (typically upon completion of vesting) and for a pre-determined purchase price. This solution gives the team member high legal certainty but is more complicated and costly for the startup as it binds the startup to transfer the actual shares. It is therefore suitable for later stage (post-Series B) and joint-stock companies (or simplified joint-stock companies in Slovakia). Taxation is also more complex in this case, but may ultimately be more advantageous. However, we recommend working with a tax advisor.
A team member acquires a real share in the company upon vesting. The team member thus becomes a shareholder of the startup (just as the founder is). Thus, they will legally have certain rights, such as the right to information or the right to be invited to the General Meeting, which can complicate the startup’s routine administration. A real share in the company as part of an ESOP is therefore not a viable option if a large number of people are involved in the ESOP in the early stages of your company. If your startup turns into a joint-stock company (a.s.). or, in Slovakia, a simplified joint-stock company (j.s.a.) in the later stages, you may want to consider granting employee shares. Taxation is more favorable in this case. We recommend working with a tax advisor when granting employee shares.