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3 things first-time founders should know about ESOP implementation

Published on March 26, 2024

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Employee Stock Ownership Plans (ESOPs) are essential for startups globally, serving both as a mechanism to sync key team members with the company’s long-term goals and as a way to attract and retain talent.

Globally, startups allocate between 13% and 20% of company equity to ESOP programs. In Asia Pacific (APAC), this figure is slightly more conservative, with allocations ranging from 10% to 12%. Notable in the region, early significant hires typically receive around 0.5% ownership of a startup.

In 2023, AC Ventures conducted a benchmarking study across its portfolio companies to examine the adoption and effects of ESOPs. It then used the data to develop a playbook for founders titled “Unpacking ESOPs for Startups” in collaboration with US-based cap table management and valuation software Carta

The study identified the primary reasons for ESOP implementation as building a sense of ownership among employees (27%), attracting new talent (25%), and retaining existing staff (23%).

The survey also highlighted strategic equity allocation practices aimed at creating a motivated startup team. Early-stage ventures tend to set aside a larger share of equity, often 10-20%, before significant funding rounds, such as series A and beyond. 

According to AC Ventures’ findings, about half of its portfolio companies that have implemented ESOPs allocate 5-10% of company shares to these programs, primarily those in the early stages with valuations still less than US$100 million. Here are three key takeaways for first-time founders.

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Allocate equity strategically and plan ahead

Before pursuing significant funding rounds, make sure to strategically allocate an appropriate percentage of equity to the ESOP pool. Prepare a detailed organizational plan that forecasts ESOP issuances for the next 12 to 18 months, focusing on the compensation needs of both current and future key personnel.

Equity helps make up for lower wages in the early stages of growth and creates a sense of belonging and dedication among employees. By setting aside an ESOP pool early on, startups can also potentially avoid dilution of the founding team’s shares later on, and keep enough equity available for future vital roles. Be sure to familiarize yourself with the common types of equity for employees.

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Carefully select ESOP recipients

When choosing who gets equity, companies must be careful and decisive. A clear set of eligibility rules, possibly linked to performance goals, helps cultivate a meritocracy, rewarding those who contribute significantly to the company’s objectives.

Broadly offering ESOPs can promote a sense of inclusion and teamwork, while selectively granting them can be a potent tool to keep top talent. Firms must communicate the criteria for eligibility transparently to ensure everyone is on the same page and feels fairly treated.

The process for awarding ESOPs is typically structured in stages: 

  • First, the company’s leadership or a special committee identifies and selects employees to be offered ESOPs, deciding how many options each will receive. 
  • Next, employees have a set period to formally accept these options, which involves signing and returning an acceptance contract. 
  • Finally, those who accept can claim their shares according to a predetermined schedule. While ESOP policies vary from company to company, they must always comply with the relevant legal standards, and participation is usually at the company’s discretion.
Map out vesting schedules and liquidity opportunities

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ESOPs typically involve a vesting schedule over four years, starting with a “cliff” of one year during which no shares vest, followed by monthly vesting.

Apart from the standard vesting schedule, companies might offer alternative schemes based on performance or specific achievements, sometimes providing more immediate benefits without the initial waiting period. 

Another crucial aspect for employees is liquidity—how they can convert shares into cash. Companies may facilitate this through secondary transactions, where employees can sell their shares, or through direct buybacks, where the company repurchases shares from employees.

Relevant to the APAC tech scene, specifically, M&A deals also present a common exit strategy, directly impacting ESOPs. If your startup gets acquired by a bigger company, you will need clear communication about how the acquisition affects ESOPs to maintain transparency and trust within the team. 

Founders should always work with finance experts to ensure fair valuation of ESOPs during these transitions, looking for ways to integrate employee stakes with the new entity seamlessly. This thoughtful approach to ESOP management underscores the importance of these plans in attracting, retaining, and motivating key talent in the region’s competitive tech industry.

Download the full playbook via: https://acv.vc/resources/unpacking-esops-for-startups/