Everything you should know before creating an ESOP

Whether you're setting up your legal entity or getting ready for a fundraising round, I'm sure you've heard the acronym ESOP thrown around at least once.

If this is all new to you, here are some questions you may be asking yourself – with answers!

What is an ESOP?

ESOP stands for Employee Stock Ownership Plan, and it is an employee incentive plan often used to attract and retain top talent – think of it as the ultimate employee benefit. It sets aside an amount of shares of the company, called the equity pool or option pool, and establishes the terms and conditions for offering employees an opportunity to buy company stock at a set price, according to a timeline known as vesting schedule.

Why should I create an ESOP?

Many investors require that a company has one before they consider a commitment. It is an incredibly powerful recruiting and employee retention tool, seeing as stock options are something seasoned startup employees expect as part of their compensation package, and it is also a great way to create a sense of ownership shared by every member of the team.

How big should my option pool be?

It all depends on your hiring and retention needs. If you want an A team, you will need a big enough pool for them to swim in. One executive key hire alone may take up a significant percentage, although most grants range from 0.05% to 0.5% per employee with this percentage decreasing over time as your cap table grows. Common pool size benchmarks range from 5% to 15% in early stage companies, but you shouldn't rely on benchmarks alone for this decision – make sure to check with your investors and advisors. Remember to account not only for your immediate hiring needs but also for your longer-term ones, typically until you plan your next fundraising.

What should I know before I create an ESOP?

ESOPs dilute founder and early investor ownership in the company. If you and your co-founders owned 100% of the company before creating an option pool and you decided to set aside 15% for equity incentives, the co-founders’ ownership will total 85% after the plan is created. Planning on implementing an ESOP in early stages means you will have more leverage in avoiding dilution during future negotiations – that's because neither the founders nor the investors would need to compromise on shrinking their ownership percentage to make room for it.

At what point should a company establish an ESOP?

There is really no hard set rule on this. If you plan on fundraising from international investors, the topic is likely to come up during negotiations, so having a foundation to build on top of will make things simpler – always talk to your investors and lawyers before deciding to implement one.

Can I change my ESOP later?

ESOPs can be amended with shareholder/board approval, so you can start small and later increase it should that feel more comfortable. If you’re considering amending your ESOP, make sure to check with your legal team on best practices.

What happens if we don't distribute the entire stock options pool?

An ESOP can be discontinued, but you'll definitely need legal advice to get it done. The stock pool doesn't expire, though, so you can always issue the remaining stock as part of a performance incentive for the star players in your team, or as grants for your later hires.

What's a vesting schedule?

A vesting schedule is the timeline for when an option grant holder will be able to purchase shares; it exists to ensure that people don't just join your company, buy shares and then leave. Most companies set a minimum tenure an employee needs to have before being eligible to start buying shares, and that tenure is known as a cliff. The most commonly seen vesting schedule is 4 years with a 1 year cliff.

Can I decide about stock options after formation?

Yes you can, but we suggest making the decision early on to simplify fundraising and optimize your hiring plans.

Can I cancel my ESOP?

You can cancel the remaining shares, but not unless the employee has left the company before vesting all or some of their options. It's important to note that even if you cancel them, these shares do not return to the founders. Instead, they increase the ownership percentage of all shareholders, a rare phenomenon called reverse dilution.