Factors to consider while implementing ESOPs

Factors to consider with implementing ESOPs

Though there are a lot of advantages in ESOPs, there are a number of factors to consider:

  1. Setting up the ESOP is complicated

Setting up an ESOP is a flexible but complex procedure with a lot of rules and regulations to be followed in each aspect and many different scenarios to consider. The initial cost of setting up an ESOP is quite high and should involve a lawyer.

  1. What percentage of equity to put aside for your ESOP

There is no real hard and fast rule about how big your ESOP should be. However, it is recommended that the company should set a limit on the amount of equity that it wishes to share with the employees. For example, a company might set aside between 5 – 15% of the equity to be offered as ESOPs with each employee being given a right to buy equity between 0.5% to 3%.

  1. ESOPs dilute equity shareholding

Along with other activities like fundraising, ESOPs result in ownership being distributed among a lot of individuals, which means that the founder may be left owning only a very small part of his company. This can sometimes cause complications when the company ‘exits’ (eg is sold or merges with another company).

To avoid a situation where option holders are able to block the company’s sale or merger, the company’s board of management should include a clause for drag-along rights that enable a specified majority of shareholders to force minority shareholders to sell their shares on receipt of a third party offer.

For a great example of how a startup journey might experience dilution through first hires, seed rounds, and series A, check out Alexander Jarvis’ medium article, “How does startup dilution work for founders, ESOPs, and investment

  1. What happens when an employee leaves a company after shares have vested

The ESOP agreement should clearly contain a provision as to what happens when an employee who holds an ESOP leaves the company. Generally, an outgoing employee forfeits all his unvested options but retains the vested options till a specified short period of time.

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