Startup Employee Stock Options Plans (ESOPs)

1 Startup Employee Stock Options Plans (ESOPs) Overview and Best Practices Table of Contents Part I: Intro to Options Plans What is an ESOP? What is an Option? Lifecycle of a Startup ESOP Common Terms in an Options Package Why Issue Options to Employees? A Defining Characteristic of Startup Culture A Necessary Part of the capital Structure When to Create an ESOP? Communicating Options to Employees: % versus $ Part II: How Much to Grant Two Approaches The Top-Down Process 1. How Much Equity to Set Aside in the ESOP?

2 2. A Typical Distribution Schedule The Bottom-Up Process 1. Segment Your Human Resources 2. Establish Pay Multipliers for Each Role 3. Determine the Dollar Value of the Options Grant 4. Determine the Current Share Price 5. Calculate the Options Grant An Example: Hiring a CTO Important Takeaways Part III: The Fine Print Terms Strike Price Vesting Schedule The Cliff Example: Standard Vesting w/ a Cliff Vesting in a Liquidity Event Exercising Options Tax Considerations Legal Advice Part IV: ESOPs for the Long Term Retention Grants Discretionary Grants Social Impact Considerations Options Modeling Overview Options Modeling A Detailed Example Part V.

3 Resources & Further Reading INTRO TO Options Plans Part I What is an ESOP? An Employee Stock Options plan (ESOP) An allocation of shares that will be granted to employees in the future in the form of Stock Options How much equity should we set aside for employees? A plan for how these Options will be distributed: How many shares will individual employees receive? What terms will govern these grants? The plan is as important as the allocation! What is an Option? Why do Options have intrinsic value? A effective form of equity ownership A locked-in price for shares How do startups use Options ?

4 To bring in founding team members who are not co-founders To recruit, compensate and retain early employees To allow later employees to share in the company s long-term upside Terminology: This presentation uses Options generally to refer to several types of securities that are often issued to Startup employees to provide for effective equity ownership, including: - Stock Options (the right to buy common Stock a set strike price) -Restricted Stock (common Stock issued early on to top employees) -Restricted Stock units (a promise to issue common Stock in the future) Appropriate use of these securities will vary based on local regulatory and tax considerations.

5 An option is a right (but not an obligation) to purchase a quantity of a company s Stock at a set price for a certain period of time Lifecycle of a Startup ESOP Founders and early investors create an ESOP by setting aside a percentage of shares to be granted to future employees Management and the Board of Directors issue these shares to employees as Options packages granted for hiring, promotion and retention Employees receive all of their Options upfront, but the company maintains a right to force forfeit that diminishes over time through a process called vesting Options are exercised by employees when the company is acquired or taken public.

6 The Employee pays the strike price to acquire the shares, but those shares are now marketable at a higher value Common Terms in an Options Package Number of Shares The total number of Options granted to an Employee , and therefore the maximum number of shares that Employee has access to Strike Price The price the Employee must pay to purchase each share if and when the Employee chooses to exercise the option Vesting Schedule The timeline over which the Options become wholly owned and exercisable by the Employee (no longer subject to repurchase by the company) Cliff Period The trial period during which no vesting occurs.

7 In this period vesting accrues, but the total effect of this vesting is realized immediately after the cliff Expiration Date The last date on which the Options may be exercised and converted into common shares by the Employee We will discuss the mechanics in further detail, but these basic terms are helpful to understanding Options grants Why Issue Options to Employees? Attract Talent: Options can be used to attract top recruits, particularly engineers, product managers and other technical team members Retain Employees: Options vest over several years, creating strong incentives for employees to remain employees Align Incentives: by making employees equity owners, Options align incentives with the long-term goals of the company Reward Value Creation.

8 Options reward tangible contributions that increase corporate valuation by giving employees a slice of that value Encourage Long-term Thinking: Options typically pay off only in a liquidity event or exit, and thus push employees to build the company for long-term success The defining difference between Silicon Valley companies and almost every other industry in the is the virtually universal practice among tech companies of distributing meaningful equity (usually in the form of Stock Options ) to ordinary employees.

9 A Defining Characteristic of Startup Culture Steven Johnson, Technology Writer Startups are a unique case. Unlike at larger corporations, Employee ownership is an essential element of Startup communities and culture As high-risk/high-reward enterprises, startups use Options to align Employee compensation with the risk-prone mentality of the business Startups seeking to achieve a big exit use Options to align all employees to drive toward this desired outcome A Necessary Part of the capital Structure Venture capitalists require ESOPs.

10 For many VCs, establishing a Stock option pool is a prerequisite to closing a deal In an industry where Options are ubiquitous, startups are compelled to offer Options packages to compete for top talent with other venture-backed companies When operating budgets are tight, competitive compensation packages may not be possible; Options can be used to incentivize employees instead of cash I can't think of a term sheet that we have issued that didn't have a specific provision for Employee equity. Fred Wilson, Union Square Ventures When to Create an ESOP?