Employee Stock Option Plan (ESOP): For Startups

The term employee stock option plan is a bit of a misnomer. It’s a pool of equity that a company reserves to issue stock options, in addition to stock grants and potentially even restricted stock units (RSUs). Perhaps a better name would be an equity incentive plan. For the purposes of this article, we’re going to use the colloquial term “option pool.”

What Is an Option Pool?

An option pool is a certain number of shares of common stock set aside as compensation for employees, advisors and contractors.

In startups, most team members receive some equity. Startups use equity compensation to create an ownership culture, attract and retain top talent, and incentivize hard work and direct contributions to the company’s growth. This compensation can take the form of stock options, restricted stock or other equity-based incentives. The goal is to incentivize employees to commit to the company long-term and to perform well.

Equity incentive plans can be an attractive form of compensation for employees since they offer potential financial gain if the company performs well in the future. Additionally, these plans align employee interests with those of shareholders, which can lead to increased productivity and profitability for the company.

Create the Option Pool as Soon as You Incorporate

A common mistake founders make is to issue all of the authorized shares in the company to the founders, without reserving any for the option pool. The problem is that if you do that, you’ll have no shares available to incentivize employees.

In order to avoid this, create an option pool first, then divide the remaining shares among the founders. The size of the option pool is determined by several factors, such as the stage of the startup, its financial resources and the number of employees it plans to hire. Option pools typically range from 10% to 20% of a startup’s total equity.

So, say three founders incorporated Gregarious Games Inc. with 10 million authorized shares and they want to split the equity evenly among them. They should first set aside the option pool. In this case, they’ve decided on a 15% option pool. So, they establish an option pool with 1.5 million shares, then they divide the remaining 8.5 million shares evenly among the founders.

Approval Process for an Equity Incentive Plan

The option pool is governed by an equity incentive plan, which sets the guidelines around employee issuance and ownership of equity. The approval process for an equity incentive plan involves several steps. First, the board of directors or compensation committee designs the plan and determines its terms, such as the number of shares in the pool, the administrators of the plan, restrictions on stocks and stock options, as well as exercise window. 

Once the plan has been designed, it is presented to stockholders for approval. This is typically done through a written shareholder consent that outlines the details of the plan, and provides stockholders with a chance to review and approve on it.

The purpose of stockholder approval is to ensure that these plans align with the interests of shareholders and do not dilute their ownership. Stockholders will review the proposed plan and vote on whether or not to approve it. If the plan is not approved, the company may need to revise its terms or seek alternative forms of compensation for employees.

Stockholders can then ask questions about the plan and voice any concerns they may have. If a significant number of stockholders oppose the plan, it may need to be revised or withdrawn.

Assuming the plan is approved by stockholders, it can be implemented by granting options or other equity incentives to eligible employees. The company must keep detailed records of all grants made under the plan and ensure that they are in compliance with applicable laws and regulations.

It is important for companies to follow proper procedures when designing and implementing equity incentive plans. By doing so, they can ensure that these plans are effective in retaining top talent while aligning employee interests with those of shareholders. Additionally, following proper procedures can help build trust and transparency between management and shareholders, which can lead to long-term success for the company.

In practice, both the board and shareholders often approve through a written consent in lieu of a meeting.

If you need legal counsel to help draft an equity incentive plan, feel free to reach out to us here.


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