Employee share option plans (or ESOPs) are a key tool for Kiwi startups to incentivise staff and hire talent when funds are tight.
We’ve put together this guide to help you consider the key terms of your ESOP. If you want help on the process of adopting your ESOP, granting options and all the necessary approvals, check out our separate guide here.
In this guide, we refer to employees generally as the likely recipients of options. However, options can be granted under an ESOP to anyone providing services to a company, for example, a director or contractor. You just need to make sure you’re applying the right securities law exclusion for the recipient. Our template ESOP rules are flexible enough for a company to use them to make grants to any individuals in those roles.
how big should your option pool be?
Usually an ESOP pool is around 5-15% of a company’s total shares on a fully diluted basis (10% is pretty common). If you are setting up an ESOP as part of a capital raise, your incoming investors may have requirements around the ESOP pool size.
Generally speaking, when you’re raising capital, investors will expect founders and existing shareholders, not the investors themselves, to take on the dilution from an ESOP (i.e. an investor’s agreed stake in the company is calculated on a fully diluted basis, taking the ESOP pool into account even if the ESOP has not been formally put in place at that point).
This means it’s important to ensure your ESOP pool is not significantly larger than required for your foreseeable hiring needs, as that chunk of equity may only be diluting founders and other existing shareholders. Consider the best balance between making sure you’ve set up a big enough pool to attract talent, and avoiding unnecessary dilution.
Your first ESOP pool won’t necessarily be your final ESOP arrangement. As companies grow and go through multiple financing rounds, it is not unusual to see the size of the ESOP increase so key hires can be made during the growth phase.
how much will it cost employees to exercise their options?
The exercise price is the price that an option holder must pay to exercise their options to purchase shares in the company. This is decided on a case-by-case basis for each option holder and set out in individual grant letters.
From a legal perspective, the Companies Act 1993 requires that directors of a company issuing options be comfortable (and resolve and certify) that the exercise price is fair and reasonable to the company and to all existing shareholders. Beyond that, directors of a New Zealand company have broad discretion to set the exercise price.
The exercise price is often fixed at the market value of the company’s shares at the time the options are granted (for example, by reference to the share price in the company’s latest funding round). Employees then benefit as the value of the company increases from the date they receive their options, incentivising them to help grow the company’s value.
However, exercise prices can also be set significantly lower than this market value, where the directors think it’s fair and reasonable to do so.
A company may grant options with a nominal or discounted exercise price to reflect the fact that the employee has worked for the business for some time, and may have been promised options earlier (at a time when the market value was lower).
Some companies and founders prefer to set the exercise price as low as possible. The intention being to give employees the best incentive to help grow the company’s value, because their potential gain on exit starts immediately. It also protects employees if the company hits a rough patch and the market value for its shares at exit, or on exercise, has fallen significantly. You may find investors are resistant to this approach, and it won’t make sense for all companies.
how will the options vest?
Options are only valuable if they can be exercised. To encourage key team members to stay with the company long-term, options generally vest (become exercisable) over an agreed period, typically 3 or 4-years and often with a cliff that requires the employee to stay with the company for 12 months before any options vest. If an option holder leaves before the end of the vesting period, they will usually lose their unvested options.
Our template ESOP rules allow for recipients to have personalised vesting schedules on a case-by-case basis. Where an employee has already worked for the company for a long time before receiving options, a company may recognise that prior contribution by applying a shorter vesting period than would otherwise apply to a new hire, or by applying the same 3 or 4-year vesting period as other ESOP participants, but back-dating the start date of the longstanding employee’s vesting period.
We generally recommend keeping things simple by sticking with time-based vesting. If you do want to have options vest as the employee achieves certain milestones or KPIs, ensure that the thresholds are objective, easily quantifiable, and clearly described in the option documents. Anything less, and you risk misunderstandings leading to disputes between the company and a valued team member.
how long will employees have to exercise their options?
The expiry date of an option is the last date the option holder can exercise that option. This is often aligned with the expected time frame for the company to find an exit, for example, 7-10 years from the date of grant, but of course this depends on the company’s stage and maturity. On the expiry date, unexercised options lapse.
Consider whether the expiry date should be brought forward if the option holder leaves (we discuss this in more detail below). The most employee-friendly ESOP terms do not change the expiry date. This approach gives the option holder the remainder of the expiry period (or until an exit event occurs, whichever comes first) to choose whether or not to exercise their options that vested before they left the company. However, as explained below, a company will often prefer for the expiry date to accelerate if an employee ceases to work for the company.
In New Zealand, tax is a key factor when an option holder is deciding if, and when, they want to exercise their vested options. There is no upfront tax liability when options are first granted to an employee in New Zealand. Typically, an employee will only be required to pay tax when they exercise vested options, at which point they will be taxed, at their marginal tax rate, on the difference between the exercise price and the market value of the underlying shares at that time. So, the longer an employee takes to exercise their vested options, technically the higher the amount of tax payable, assuming the company’s valuation increases. An option holder needs to balance the potential for tax-free capital gain (by exercising their vested options sooner rather than later) against their risk appetite (they may not see a return on the cash they pay to exercise the options and to satisfy their tax bill). For this reason, many employees prefer to hold off on exercising their vested options until an exit event occurs – eliminating downside risk and giving the employee the cash proceeds from the exit event to pay their tax bill. It also explains why employees will generally prefer the expiry date to be as long as possible, and not to accelerate if they leave.
Finally, some companies provide that ESOP options may only be exercised on an exit event. This may be because the founders want to keep the number of shareholders as few as possible but still want to encourage team members to achieve a successful exit. In that case, the company may need to consider how that approach affects other key commercial terms of the ESOP, to ensure the plan is attractive and actually achieves the goal of encouraging people to stay and contribute to the company.
what about leavers?
If an option holder leaves the company for any reason, typically all unvested options as at the leaving date are cancelled without compensation. Most companies follow this approach.
There is more variation between companies when it comes to how an option holder’s departure affects vested options. The approaches tend to fall into two categories – one approach allows the option holder to retain (and exercise) the options that have vested as at the exit date until the expiry date. The other approach requires the option holder to exercise their options within a certain period following their exit date (for example, within the following 3 months), otherwise those vested options lapse. Accelerating the expiry period after an option holder’s departure lowers the company’s administrative burden of keeping track of departed employees who continue to hold unexercised options. Like all of the key ESOP terms, the company needs to balance its own circumstances and concerns against what’s fair and reasonable (and likely to be attractive) for the option holders. If option holders see little chance of ever being able to see a return on their options, a company may find that its ESOP isn’t as successful an incentive as first hoped.
Occasionally, companies also seek a right to repurchase vested options as well from leavers, or even shares that have been issued on exercise of vested options, at an agreed price (which is typically fair market value). This gives the company the flexibility to remove ex-team members as future/existing shareholders and reissue more options to incoming hires out of the overall incentive pool. You’ll see that our template ESOP rules include optional drafting for companies who wish to do this.
Finally we sometimes see bad leaver provisions incorporated. Under these, if an employee leaves in certain limited adverse circumstances (e.g. involving serious misconduct), they may lose all options (whether vested or unvested) for nil.
what happens at an exit event?
This is likely to be the part of your ESOP which requires the most thought. Our template ESOP rules provide for single-trigger acceleration on an exit; that is, all unvested options accelerate and immediately vest on an exit event and can be exercised in full. Single trigger acceleration is the most employee-friendly position and encourages all option holders to work towards an exit as soon as possible.
However, potential buyers of your company can be put off by full single trigger acceleration if they want to retain key employees in the business after the acquisition (and the potential buyer sees the continued vesting of options as a way of encouraging that). For that reason, some companies prefer partial acceleration or double trigger acceleration to make their business as attractive an acquisition target as possible.
We find there is a lot of variation in New Zealand on this point. Single trigger remains the most common, especially compared to the US where double trigger acceleration is more widespread.
The different scenarios are summarised below:
|no acceleration||none of the unvested options vest on an exit event, and any unvested options lapse. Option holders can only exercise options which have vested. This is not attractive to option holders and not particularly common.|
|single trigger acceleration||100% of the unvested options immediately vest on an exit event. This is the best scenario for option holders but increases the chances that key cashed up employees immediately leave following the acquisition.|
|partial acceleration||a set percentage of the unvested options vest on an exit event. The remaining options continue to vest in accordance with the vesting schedule. This might be a fixed percentage or might sometimes exclude options that have been granted in the last 12 months. It can be preferable to a buyer for employees to remain employed by the surviving entity, so that they continue to work for the business and earn their options. This is clearly less appealing to employees, who could lose unvested options if the buyer terminates their employment after the exit, even if that termination is without cause.|
|double trigger acceleration||a set percentage of the unvested options vest on an exit event. The remaining options only vest on a second trigger, e.g. the employee being terminated (or resigning with good reason) in connection with, and within a certain time after, the exit event. That way, if the second trigger event does not occur, the employee must stay with the company in order to earn their remaining unvested shares. However, if a buyer does not choose to keep an employee after an exit, the employee is not penalised for this. In New Zealand, we don’t see double trigger acceleration very often but can perhaps expect that to change as some of the larger tech companies start to adopt Silicon Valley practices.|
Of course, any scenario that anticipates some form of continued vesting only works if the option plan can somehow survive the liquidity event, or for example the buyer provides an option plan on equivalent economic terms as the option holder has pre-exit.
Finally, it is also worth including provisions in your ESOP rules which can facilitate an exit transaction. For example, give the company’s board of directors the discretion to decide the best structure for dealing with the options, as long as the end result ensures that the option holder still benefits from the exit alongside the company’s shareholders. That may include the company cash settling some or all of the options by paying the holder the difference between the value of the shares on the exit and the exercise price of those options (as opposed to issuing and then transferring the shares). Also, as not all exits are fully satisfied in cash, that may also look like enabling a deal where option holders receive part cash and part shares in the buyer.
In the US, stock option plans have become fairly standardised. Here in New Zealand, despite ESOPs increasingly becoming a common feature of startups, their terms vary much more much according to founder and investor needs. The best advice is to ensure that the board has discretion on certain key terms, particularly dealing with leavers and acceleration. The last thing you want are difficult option holders impeding a potential exit transaction because the ESOP terms are unclear or inflexible.
If you would like to discuss drafting an ESOP for your startup, get in touch.