An essential guide to ESOPs

An ESOP is a way for you to set aside a pool of shares in your startup that you can allocate to various team members (e.g. employees, consultants or advisors – that’s right, it’s not just for employees, notwithstanding the name). The ESOP sets out the rules for granting these shares. It is usually accompanied with a specific grant agreement that you sign with each team member with the specifics of their share grant (e.g. number of shares, vesting period and vesting frequency – see below for further details). We will go through the reasons for having an ESOP, the important concept of vesting and a comparison between classic plans and phantom plans.

Why have an ESOP plan?

Three key reasons: to attract, align and retain.

1. Attract. As a founder of an early-stage startup, you’ll have to compete with corporate salaries that you might not be able to match when you’re hiring your first team members. Share Incentive Plans can be one of the tools that help you compete by offering your team the potential of a monetary reward in the future if your startup is successful.

2. Align. Having shares under an ESOP will make your team feel more invested in your startup and its growth by aligning them with the founders and giving them an owner’s mentality.

3. Retain. Finally, ESOPs help retain talent in your startup for the longer term because the shares granted under them take time to vest (see below for further details).

What is vesting and why do you need it? 

You’ve probably heard the term “vesting” before. It’s an important concept and one you need to understand to effectively manage your startup. Vesting is the term used when shares awarded to someone in a company are issued as “options” and have to be earned by that person, typically over a certain period (referred to as a “vesting period”) before the actual shares are issued. For example, 10,000 shares could be subject to a four-year vesting period, where 625 shares would vest each quarter (this is the “vesting frequency” and can also be monthly or annually; though quarterly is more common) for four years until the full 10,000 shares become vested.

Vesting vs. Reverse Vesting

If the shares are already held by the person, this is “reverse vesting”, which means the shares are fully owned by that person, but if the vesting period is not completed, they would have to transfer some of those shares back to the company. This is more typical for a founder who already holds all their shares in their startup.

If the shares are not yet held but are being awarded to the person, this is simply called vesting, and the shares are issued to the person as per the vesting schedule (e.g., in our example the person would receive 625 shares every quarter). This is more typical for shares granted under an ESOP to team members.

So, what does a person have to do to keep their vesting schedule going? Usually, it’s not much more than continuing to be employed by the company. If they leave or are terminated, the vesting schedule stops, and any shares not yet vested at that point (“unvested shares”) will either be returned or will not be issued.

The typical cliff period is one year in a four-year vesting period. This means that during the first year, no shares would vest quarterly. Instead, at the end of that year a full quarter of the shares would vest. In our example, that would mean no shares would vest for the first year and at the end of that year a full 2,500 shares would vest. After the end of the cliff period vesting would continue as usual in accordance with the vesting frequency chosen (e.g., quarterly).

What does this mean for you as a founder? 

Well, vesting (or reverse vesting) is a really important tool both in the context of fellow co-founders as well as employees, consultants or advisors that you are thinking of granting shares to.

Reverse vesting ensures each founder makes the contributions that were agreed to at the outset and stays with the startup for a minimum period. Without this, you may find yourself in a situation where a founder does not live up to expectations or decides to leave after a short period of time and keeps all their shares. This could be viewed by other founders as an unearned reward, causing resentment and depriving them of the share allocation they may need to give to a new co-founder.

For other team members, vesting ensures that they remain aligned and incentivised to stay with you and grow the business with share compensation awarded over time rather than all at once.

Classic vs. phantom plans

ESOPs come in many forms. We will focus below on two of the main types of plans, classic and phantom. Classic plans are the more traditional of the two and involve issuing actual shares in your startup to your employees, consultants and advisers. Phantom plans substitute issuing of actual shares with phantom or synthetic shares. These are basically contractual rights that aim to replicate the economic benefits of holding shares without issuing any shares (a phantom share is just a term to describe economic rights under a contract).

Key features of classic plans

Classic plans are the most popular and the one you are most likely to come across. Most people are familiar with the concept of a classic plan where shares are issued in the name of the recipient.

Benefits of a classic plan:

1. A familiar structure that parties will be more comfortable with
2. Employees, consultants and advisers will feel a higher sense of ownership if they hold actual shares
3. Funds on an exit likely to flow directly to the employees, consultants and advisers

Drawbacks of a classic plan:

1. They involve a lot more time and cost (think having to gather KYC, make filings, update registers etc.)
2. As you scale, your cap table can get very cluttered with a lot of small shareholders
3. Employees, consultants and advisers may be required to sign documents in case of an exit.

Key features of phantom plans

Phantom plans are a newer concept. They remain less well understood in most markets but can offer flexibility.

The key benefits of a phantom plan:

1. Much cheaper, quicker and easier as there are no shares to be issued, filings to be made or additional documents to be signed on an exit
2. Allows you to keep a much cleaner and simpler cap table
3. Still provides for the same economic benefits to plan participants

The key drawbacks of a phantom plan:

1. More explanation is required to gain acceptance of replacement of actual shares with phantom shares
2. The startup needs to track and record the phantom shareholders in addition to the shareholder register to maintain an accurate fully diluted cap table
3. Your startup may have to administer and pay out large sums of cash after an exit

In summary

• ESOPs are a great way to attract, incentivise and retain team members for your startup.
• One of the main features of ESOPs is vesting (earning the share options over time before they are issued as shares).
• Watch out for the difference between vesting and reverse vesting.
• You can create your ESOP as a classic plan that issues actual shares or a phantom plan that issues share-like contractual rights.

Creating an ESOP on Clara

You can create your ESOP online on the Clara platform in just a few clicks. You’ll first create your plan and adopt it by board resolution (which will be autogenerated for you by Clara and sent for signature through our DocuSign integration). Then the ESOP pool will automatically appear on your cap table. Finally, you’ll be ready to issue share options to any team member by generating a grant agreement. Once it is signed, your cap table will automatically be updated showing that team member and their share options, as well as their vesting schedule, with automated reminders! Clara also autogenerates a simple FAQ document that explains the mechanics of the ESOP in plain language and is a great document to share to your team member to explain how it all works and what it means for them.