An employee stock option plan (ESOP) is a legal document permitting the company to issue stock options to certain insiders of the company: employees, directors, advisors and consultants. The ESOP is used as an ownership incentive for the team to build the value of the business for shareholders as well as for their own benefit. It is a key compensation tool in technology businesses to attract, motivate and retain a great team.

The overall size of the stock option pool

Stock option pools typically range in size from 10% to 20% of the company. The amount is negotiated by management, investors and existing shareholders as the stock option pool represents a potential dilution (i.e., reduction in ownership) for all of these groups. In later-stage companies, the pool is generally smaller as the value of the underlying shares has increased.

With each round of outside investment, the stock option pool is usually replenished with fresh options. These are used to attract additional team members and to potentially top up the shares held by key members of the team whose performance has been strong and whose efforts will be critical to achieving the business goals. Management should develop a forecast of option grants based on their hiring plan to ensure the company has sufficient options available for recruiting and retention purposes.

Allocation of the stock option pool to employees and team members

In an average 15% stock option pool where there are 1,176,471 shares outstanding, the number of stock options available would be 176,471. The venture capital “rule of thumb” allocation would be:

  • 58,824 options or 5% for a CEO that has replaced a founder in this role—if the founding CEO is still in place, then this allocation would be spread among other categories and may be used for an Executive Chairman or key board members who are active with the business
  • 58,824 options or 5% for the executive team, with an average grant of ~1% per executive (sales executives with a variable potential financial benefit generally hold lower amounts of options while C-level executives like COO, CTO and CFO would hold a higher amount)
  • 58,823 options or 5% for all other employees, including outside directors and advisors

Entrepreneurs should seek advice from peer companies to determine comparable equity grants for roles in their company

Directors and advisors generally work for an equity-only interest in the business and the typical range is 0.25% to 0.5% of the company. For a superstar in your sector, most entrepreneurs or VCs would go as high as 1% to 2% of the company.

If the candidate wants significantly more, you’re better to move on to an alternate as this person is more interested in making money than helping you meet your business goals. They need to share your vision and excitement for the business and believe in the potential. This also holds true when recruiting key members of your management team.

Founders generally hold significant equity interests in the business and usually do not receive stock option grants through early rounds of financing. However, they may be offered option grants in later-stage rounds to motivate and retain them.

Early-stage work for equity or combination of cash and equity

There are many individuals and organizations that provide CxO-level (i.e., CEO-, COO-, CFO- or CTO-level) services to early-stage businesses on a part-time or full-time basis. A number of these resources are willing to work for equity or a combination of cash compensation and equity.

The equity component may include shares at the same price as the issuance of founder shares if the individual comes on board at the time the venture is founded, or at the fair market value as determined by the board of directors. The equity component may also be a grant of stock options that appropriately reflects the position they hold within the company and the amount of time they spend on the business.

Keep in mind that there can be taxation consequences of issuing equity or stock options. Companies must also comply with securities legislation in jurisdictions where they have ESOP members.

References

Salary.com. Retrieved April 14, 2009, from http://www.salary.com/advice/layouthtmls/advl_display_nocat_Ser56_Par123.html.
ESOP Builders Inc. Retrieved April 14, 2009, from http://www.esopbuilders.com/greatlinks.html.