As a startup founder, you are likely to come across the term “vesting” throughout your conversations and readings about Employee Share Option Plans (ESOP). Vesting is a mechanism which releases shares or options to the recipient over time or certain milestones, or both. Vesting is an important element of your overall ESOP as it incentivises your key talent to remain with the company while their options remain unvested. This also signals structural stability to future investors that the company can deliver on its product or service and overall vision. This article will explain how your company can implement and execute a successful ESOP.
LegalVision’s Employee Share Schemes Guide is a comprehensive handbook for any startup founder or business owner looking to attract and motivate top employees with an Employee Share Scheme.
What is Vesting?
It is common to have vesting provisions in your ESOP whereby your employees and contractors (ESOP participants) earn their options over time. Each time you make an offer to one of your ESOP participants, you can specify whether their options will be subject to a particular performance-based milestone or time-based release mechanism. When implemented correctly, you can force ESOP participants who depart your company to forfeit any options that remain unvested.
Standard Vesting Conditions
The typical vesting for ESOPs is time-based over a period of four years with a one-year cliff. A cliff is a minimum period your ESOP participant must continue their engagement with your company before any of their options begin to vest. Once your ESOP participant clears the cliff, their remaining options will vest over a monthly or quarterly basis.
Typically, you have a high level of flexibility when setting vesting provisions. However, within startups, there is a widely accepted market standard whereby 25% of options vest at a one-year cliff. The remaining 75% vest on a monthly basis for three years (i.e. at a rate of 1/36).
General Requirements
There are no strict requirements for your ESOP’s vesting. However, there are several mechanisms you should confirm are in place to ensure its effective operation. Your ESOP Plan Rules, which is the foundational document for your company’s ESOP, should contain the following:
- Vesting Provision – Your ESOP Plan Rules need to contain a mechanism that allows you and your fellow directors to issue ESOP offers subject to vesting conditions. This clause should set out the standard vesting provisions whilst allowing you to exercise discretion on a case-by-case basis.
- Leaver Provisions – It is common to include forfeiture provisions known as “leaver provisions” in your ESOP Plan Rules. A “leaver” is one of your ESOP Participants who is no longer engaged by a group company. Your leaver provisions should give you and your fellow directors the discretion to force the leaver to sell their options. It is important for the ESOP Plan to deal with good and bad leaver situations. You should make it clear whether your company can only acquire unvested options from a leaver.
- Power of Attorney – You should ensure your ESOP Offer Letter contains a Power of Attorney clause. This will give you and your fellow directors the ability to act on the ESOP participant’s behalf should they refuse to sell or transfer their options upon receiving fair notice from the company to do so.
Key Takeaways
Consider implementing an ESOP to attract and retain key employees needed to develop your product and execute your vision. Vesting is a key element that incentivises your top talent by giving them skin in the game. However, there are general requirements your company should abide by to ensure your ESOP’s effective operation.
If you need help drafting an ESOP for your startup or would like to discuss the ins-and-outs of vesting, our experienced startup lawyers can assist as part of your LegalVision membership. You will have unlimited access to lawyers to answer your questions for a low monthly fee. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
While you are not required at law to keep a vesting schedule for each ESOP participant, it is good practice to do so to track and issue options as they vest. However, note that once you have issued options, you are required by Australian law to keep a register of option holders.
Not directly. The main consideration here is the 10% ownership threshold for the startup tax concession offer eligibility. The 10% ownership threshold includes the ultimate aggregate number of vested and unvested options as well as any existing shares or options held by that ESOP participant.
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