The first part of this article series on stock options for gaming startups addressed how startups should look at giving out stock options to their staff, by creating an ESOP, which stands for employee stock option plan.
There was a breakdown of the different variables that emphasize how much stock options should be given out: role, the person’s preference on salary versus equity, the company size, the risk level of when they joined, and the seniority of the person.
In the second part of stock options, I’ll cover some topics related to stock option allocation the first part didn’t cover. We’ll first start off with the question of when you should create the first ESOP.
- When to create the first ESOP
As stock options have become so common for startups, I’d recommend having an ESOP in place from day one.
To make it easy on the founding team, it’s important to bring up the ESOP when you’re dividing the pot of founding shares. If you’re three founders with a division of 25%, 25%, 25%, and 25%, you need to mention that the company will start off with an ESOP, and the split will go 22.5% times four, with 10% going to the ESOP. This way, the expectations are clear for everyone.
2. Funding rounds and ESOP
The investors will often require an ESOP to be created when a funding round has closed. The company will be scaling hiring with the new funding and it’s very preferable that stock options would be part of the compensation package for new employees.
If the startup still lacks an ESPO when the funding round is happening, investors will expect that an ESOP would be created in the pre-money valuation. This way, the ESOP would exist before the funding round happens, meaning that the investors won’t dilute in the process.
3. Lifetime of an ESOP and creating a new ESOP
Once you’ve created an ESOP with 10%, you can start granting stock options to your hires. I’ve heard of founders worrying about allocating all the ESOP before the next funding round happens since a new batch of stock options should be created after each round.
This is not true. It always depends on the situation. If your existing ESOP as stock options left, those will continue to be allocated until they’ve been used up. But certainly, if you’ve exhausted a good portion of the stock options available, let’s say 5% of the ESOP, it will become a conversation with your investors if another ESOP of 10% should be created when the next funding round happens.
Note that this doesn’t always sum up to 15%, as the first ESOP will dilute with the new funding round. As you’ve seen in our Cap Table Modelling article, the ESOP is a part of the cap table as its own entity, and it dilutes along side the rest of the shareholders on the cap table.
4. Strike price and how to get it right
The strike price is defined when an ESOP is created. It defines a fixed price for a given option grant and is the amount an employee must pay to buy each share. It is also referred to as the exercise price or option price.
When the ESOP is created, the strike price is usually set based on the valuation from the last investment round. If the company has yet to raise funding, the strike price could be set based on a “fair market valuation.” In any case, it’s worth consulting your lawyer on identifying this fair market valuation.
In any case, it’s beneficial to aim for the lowest possible strike price. This way, the stock options become an attractive motivator for employees.
Note that the ESOP is supposed to an incentive for employees to stick around for the long term. If you give out stock options that could be converted into shares immediately, they wouldn’t be effective for retaining people.
That’s why you’d want to have some sort of vesting mechanisms in place for people’s stock options.
Vesting is the process by which an employee is rewarded with shares or stock options, but receives the full rights to them over a set period of time. In the US and Europe, the most common vesting schedule has been four years, with each passing month of the 48 months, granting 1/48 of the options to become vested. After they vest, the employee can start converting the options into shares.
Another important part of the vesting mechanism is the cliff, which prevents options from becoming immediately available for the employee after their first month on the job. Typically in the US and Europe, no options are vested during the first 12 months. This gives companies time to weed out bad hires without suffering dilution. Once the employee hits the 12-month milestone, 1/ worth of stock options become vested.
6. Advanced vesting that guarantees long term incentive
More and more companies have noticed the problem with the twelve month’s cliff as people aren’t really incentivized by staying at the company for years on, especially in situations where a) they’ve reached the cliff and have vested 1/4 of their options, and b) where the company’s growth has stalled and there’s “greener grass” somewhere else.
There are a few models to follow, which are more beneficial to the company as they guarantee more long-term loyalty from the employee.
The mechanism of back-loaded vesting changes the amounts of vesting that happens during each year. In the traditional vesting model, each year the employee vests 1/4 of the stock options. But in a back-loaded model, there is a more significant incentive to stay on board for several years. The model would go as follows:
- 1st year: 10% vested
- 2nd year: 20% more gets vested (30%)
- 3rd year: 30% more gets vested (60%)
- 4th year: 40% more gets vested (100%)
Another mechanism has a long 36-month cliff, but with more emphasis on how the employee leaves. In this model, we first need to define the leaving conditions. The employee is a good leaver if they were dismissed without cause or had to stop working due to an illness. A bad leaver would be someone who just leaves voluntarily, i.e. to go work somewhere else or is dismissed due to cause.
- First 12 months: If the employment is terminated for whatever reason, the employee loses all stock options. In any case, none of the options are vested.
- 12 to 36 months: Still no vesting. If the employee is a bad leaver, all stock options are lost. If the employee is a good leaver, they’ll be allowed to keep part of the stock options, namely as many options as would have been vested if there was no cliff at all.
- 36 months: The employee keeps all vested stock options from here on. If the employee is a bad leaver, the Company also has the right of choice to purchase all the vested options for fair market value.
What’s great about this model is that it keeps the company shares close to the company and truly incentivizes long-term retention. People can start hopping from one company to another after one or even two years, without the possibility of losing their shares in the company.
7. Exit before cliff and vesting happens
In certain cases, when an exit happens, accelerated vesting can be applied to stock options. But it depends on many circumstances:
- Does the acquirer want to retain the employees? Would they rather want the existing stock option programs and their vesting schemes to continue so that the existing staff will be motivated by the long-term? In most exit situations, this is exactly what happens.
- If some individuals a critical to a successful exit but haven’t yet vested their stock options, it might be in the acquirer’s interest to accelerate vesting, so that all key stakeholders, especially management members with stock options, are willing to proceed with the merger or acquisition.
Most often then not, stock option programs and vesting schemes don’t change or they don’t need to change when an exit situation happens.
8. How to communicate a stock option program to employees
One key aspect of making stock options valued more is to educate employees on the benefits of owning stock options. To prepare, consult your local startup lawyer on all the country specifics around the following aspects.
- ESOP timeframe, how long the options program can exist
- Strike price implications
- Stock option exercising timeframe, after being granted, after employee leaves and if an exit happens
- Tax implications, when and how the employee and the employer will be taxed, possibly when granting options, when the employee exercises the options to convert them to shares in the company, or when the employee sells the shares in an exit, etc.
We’ve also created a video on how you can use the template.