Employee Share Option Plans (ESOP) explained
What the ESOP?
ESOPs, or Employee Share Option Plans, are a common part of employee benefits packages in start-ups and scale-ups, and Brighte is no exception. At Brighte, every new staff member is given an offer to join our ESOP program within their first 3 months.
ESOPs are a way for our staff to become owners (shareholders) at a point of time in the future, but to do so at a cheaper price than if they were buying shares in a capital raise or on an open market. What that means is that if Brighte is successful (and the share price grows in value), the ESOP can allow each of our employees to share in the company’s success.
How does it work?
Your “ESOP Offer” will contain a few elements:
- A specified number of “options” - one option is an offer to buy one share in the company at a certain price.
- An “exercise price”, which is the price that you pay to convert that option into a share. The exercise price is fixed at the time you receive your ESOP offer - so even if the company share price increases by 1,000,000%, you still pay the same amount for your share.
- A “vesting schedule” - this is a timeline that tells you when your options will “vest”, which means when they become your property.
- A set of “vesting conditions” - these are typically quite limited, for example, that you remain a current employee at the relevant vesting date.
- “Face value” - the value of the shares that you would be entitled to based on the current share price if you were to exercise your options.
Some other things that you may be interested to know, but that may not be included in your offer, include:
- The total number of shares on issue in the company (this will tell you the percentage ownership that your ESOP will give you)
- The current share price or, more likely, the share price at the most recent capital raise (this will allow you to calculate the current market value of the shares that you would have if you “exercise” your options (i.e. pay the exercise price to convert them to shares).
Being an owner is cool, but is it worth anything?
Like any type of share ownership, there are no guarantees.
ESOPs are often used in start-ups where the company has aggressive growth ambitions. If the company is successful and achieves its ambitions, often its valuation will increase, meaning the price of an individual share will rise too. Because the share price you pay under your ESOP is fixed at the time of issue, you’re able to buy a share at the old share price, even though if you then sell that share you could do so at the new share price.
Confused? I’m not surprised. Let me give you an example.
Yoda is an employee at JediCo, a start-up focused on providing mindfulness and martial arts coaching to students across the world. JediCo’s program is very popular and more and more students are signing up - over the 4 years that Yoda has worked there, JediCo has increased the number of students 5-fold each year!
When Yoda joined 4 years ago he was given an ESOP with the following terms:
Number of options: 16
Exercise price: $1
Vesting schedule: 4 shares after 1 year, and then 1 share each quarter for the following 3 years
The share price when Yoda joined was $1.20 per share, but because of the massive growth in student numbers, the current share price (based on the capital raise that closed last month) was $10 per share.
Because Yoda’s exercise price is fixed at $1, he pays $16 to convert his options to shares, which are now worth $160.
Back to reality…
Like I said above, there are no guarantees - but if the business you work for is successful, your ESOP offer can end up being worth some (or even quite a lot of) very real money.
In figuring out how much value to place on an ESOP, the question you have to ask yourself is “how much do I back this company to achieve its mission and grow in value”? The great part is, as an employee, you have a chance to influence this from the inside.
Why ESOPs and not a bonus?
Most start-ups that I have seen do not offer bonuses. This is partly because they are often “pre-profit” - i.e. the company is running at a loss while it is building scale, meaning that money may be tighter than a steady-state business that is already profitable. The other reason is that successful start-ups often deliver massive growth in share price, so an ESOP is an effective way to share the value created by that growth with the employees who have worked hard to deliver it.
What if I can’t afford to pay the exercise price?
This is a very real question, particularly in later stage start-ups where the cost of exercising the options (i.e. the number of options multiplied by the exercise price) might be tens or even hundreds of thousands of dollars. Very few people have this much cash just lying around!
Often what will happen is that employees will choose not to exercise their options (i.e. they don’t convert them into shares) until a “liquidity event” happens - for example, if the company IPOs or is sold. In this case, the options issued under the ESOP become part of the sale of the company, so the option holder would receive a payment equivalent to [(agreed price per share less the exercise price per share) multiplied by the number of options].
Still in doubt?
Take a read of the ESOP plan rules, and if necessary, seek advice from your accountant or financial advisor!
This post contains general information only. Your personal circumstances have not been taken into account so none of this information should be taken as personal advice. If you do require personal advice please contact your accountant or a financial planner.