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As a startup founder, you might be looking into ways to reward your employees despite being low on funds. An Employee Share Option Plan, also known as an Employee Stock Ownership Plan (ESOP) is an effective cash-free way for startup companies to motivate high-performing employees by giving them options to acquire company stock. Furthermore, implementing an ESOP may allow your startup to retain top talent when it cannot afford to pay a premium salary. This article outlines the key steps and considerations you should take into account when making an ESOP offer.

1. Implementing ESOP Rules

As a starting point, your company must implement the formal rules which govern the employee share option plan.

ESOP Rules set out the key features, rights and obligations applicable to the ESOP, such as:

  • participation eligibility;
  • vesting schedules; and 
  • what happens to ESOP share options if an employee leaves the company. 

Based on the company’s constitution and shareholders agreement, you will need to consider who needs to approve the company’s adoption of the ESOP Rules. For instance, whether it is just the company’s directors, shareholders, or both.

Vesting Conditions

You must remember that when the company makes an ESOP offer, the employee is only initially acquiring share options (which are a conditional right to acquire shares in the future). Therefore, the employee will only acquire the company’s shares if they satisfy the conditions.

Options issued under an employee share option plan are often subject to vesting conditions. Put simply, these are conditions that the employee must satisfy before the employee can exercise their stock options. The most common form of vesting is time-based vesting. This refers to a predetermined period of time that must expire before an ESOP participant can exercise their stock options issued under the ESOP. Typically, any unvested options will lapse if an employee leaves the company before the vesting period expires.

One common vesting period is four years with a one-year cliff. The cliff refers to the minimum period that the employee must continue to work for the company before their options begin vesting. Once the cliff has expired, the remaining options usually vest on a monthly or quarterly basis for the remainder of the period.

Finally, milestone-based vesting is an alternative to time-based vesting. This is where options issued under an ESOP are vested on achieving performance milestones. For instance, this could be completing a business project or meeting a certain number of revenue targets.

2. Calculating the Number of Options to Issue

Your company and its shareholders can agree to create an options pool in the shareholders’ agreement. This is a theoretical reservation of a portion of the company’s share capital that can be used to issue options under the ESOP.

For example, your company and its shareholders may agree to create an options pool of up to 10% of the company’s share capital. In this case, the company can issue options equal to 10% of its share capital to employees. The company is not required to issue the options upfront but can do so when needed.

To determine how many options your company can issue, use the following formula:

A x B ÷ C = D

  • A is the number of shares your company currently has on issue;
  • B is the maximum percentage of your options pool;
  • C is the percentage of the company the other shareholders will have after your options pool is fully issued; and
  • D is the number of options you can issue under your options pool.

Calculating the Exercise Price

Next, you will need to set an exercise price for your options. This price is based on the value of ordinary shares in your company when the ESOP offer is made. It is so named because it is the price employees under the ESOP must pay to exercise their options and convert them to shares. You can use the prescribed safe-harbour valuation methodologies to determine the exercise price if you satisfy specific criteria.

The most commonly used safe-harbour valuation method to determine a fair market value is the net tangible assets test. Often, this produces a low exercise price as startups rarely have many tangible assets. 

Suppose company XYZ has 1,000 ordinary shares on issue. It has no preference shares and has $5,000 cash in the bank, $5,000 in laptops and no other tangible assets. Therefore:

  • company XYZ’s net tangible assets = $10,000 ($5,000 + $5,000); and
  • your share price = $10 ($10,000/1,000).

The exercise price for an option issued under your ESOP will be at least $10.

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3. Approving the ESOP Offer

Your company’s corporate governance documents will likely require the board to approve the issue of options under an ESOP. In this case, the board will need to pass a resolution approving the issuance of the share options following the ESOP offer letter.

4. Issuing the ESOP Offer Letter

An ESOP offer letter is a personal invitation to an employee to participate in the ESOP. It typically sets out the key terms on which the employee will participate, including the number of options they will receive, the exercise price and any vesting conditions. The ESOP offer letter should be accompanied by a copy of the ESOP Rules, which the participants accept to participate in the ESOP.

The ESOP offer letter will also advise the employee on the steps they need to take to accept the offer.

5. Updating the Options Register

Finally, you can update your company’s options register once the ESOP grant has been accepted.

The Corporations Act 2001 (Cth) sets out the details that you must include in a company’s register of option holders, such as the:

  • option holder’s name and address;
  • date on which the option holder’s name is entered in the register;
  • date on which the options were granted;
  • number of and description of shares over which the options were granted; 
  • period in which the options may be exercised; or
  • time at which the options may be exercised; and
  • consideration payable for the exercise of the options.

Key Takeaways

Issuing options under an ESOP is not a decision you should make lightly. There are many essential steps that startup companies must consider and undertake before doing so. In addition, calculating the number of options to issue and the exercise price can be complicated as startups are notoriously difficult to value. Nevertheless, ESOPs, when used correctly, can be an effective tool for your company to preserve funds while rewarding top-performing employees. If you need help making an ESOP offer, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.

Frequently Asked Questions

What is an ESOP?

As a startup founder, an ESOP (Employee Share Option Plan) helps to reward your employees by giving them options to acquire shares of the company in the future.

What are the ESOP Rules?

ESOP Rules are formal rules which govern the ESOP. They set out key features, rights and obligations such as participation eligibility and vesting schedules.

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