The one perk that startups can uniquely offer is equity ownership in their own company, however, many employers do not think about how to best structure equity programs for the long-term success of the company and employees.
In this post, we will provide a framework for thinking about how to design an equity program that works for both employers and employees, which we are calling a "Employee Aligned ESOP".
Adopting an Employee Aligned ESOP scheme sends a strong signal that you’re building a company that values the contributions of employees.
Silicon Valley has long embraced the concept of equity ownership of companies for all employees. Equity grants played a key role in creating the ecosystem by generating enough wealth to help employees of successful companies angel invest and launch their own companies. In the Indian ecosystem, we see a similar trend emerging.
At EquityList, we frequently hear from companies that they take the defaults from their law firm drafting their equity plan documents, instead of thinking about what configuration will promote a company culture oriented towards growing the value of the business.
Due to the lack of set industry norms and employee pushback, companies often end up with ESOP schemes that lack certain protections for employees. One example is short exercise periods that force an employee to pay to exercise within a few months of leaving and face a potentially large tax bill.
This often results in an employee deciding not to exercise their units and leaves them without ownership in the company they helped build.
As a result of the short exercise period and lack of explanation around how ESOPs work, employees often do not assign any value on their ESOP grant despite the fact that founders and investors are diluting their own (valuable) ownership stake to offer equity to employees.
In addition, when employees lack faith in options grants, ESOPs cease being a financial incentive to grow the company and make it harder to retain employees.
Our guidelines for companies are to follow a four-point approach when designing Employee Aligned ESOP schemes:
- Offer generous exercise periods for employees:
- Offer exercises only during liquidity events and allow employees to retain their vested units after leaving the company.
- At a minimum, a seven-year exercise period post-termination.
- The company cannot retain the right to cancel vested options simply because an employee decides to leave.
- (An exception is made for cases where employees were let go for unlawful conduct)
- The vesting schedules offer frequent vesting (Quarterly or Monthly)
- The company will offer reading material to explain the terms of ESOPs and some of the potential risks.
Attracting and retaining top employees is one of the most challenging parts of building a startup. Adopting an Employee Aligned ESOP scheme sends a strong signal that you’re building a company that values the contributions of employees.