12 legal considerations when drafting your ESOP
Learn what should go into your employee share option plan
Employee share option plans (ESOPs) are a key tool for tech startups wishing to incentivise directors, employees or contractors. Whilst the concept of granting options to purchase shares in your company is simple enough, there are plenty of variables to consider when drafting the plan’s rules.
Tech startup and VC experts, Simmonds Stewart, provide a free-to-download template set of ESOP rules – a good starting point for any company thinking about adopting an ESOP.
Always speak to a lawyer when preparing your ESOP rules, but key issues to consider include:
1. Administration of the scheme: For most start-ups, the ESOP will be administered by the board of the company. Sometimes, larger companies prefer to establish a committee to carry out this role. You would need to think about who was on the committee and whether there was any real benefit in setting this up. The board or committee (as applicable) usually has the right to vary the rules at any time for the purpose of administering the ESOP.
2. Size and terms of the ESOP: ESOP rules normally set out the maximum number of options which may be issued under the plan, with a typical ESOP pool being around 10-15 per cent of the total equity of a company. If you have taken on investment, it is possible that the size of the option pool is specified in your shareholders’ agreement, as investors often like to have a cap on the size of any ESOP. If an option is cancelled or otherwise lapses, the board is usually permitted to grant additional options above the maximum cap in order to replace those cancelled or lapsed options.
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3. Exercise price: You can set the exercise price at whatever level you want, but generally it will be around the fair market value of an ordinary share in the company at the time the option is granted. This approach gives recipients the ability to share in any uplift in the value of the company going forward (and therefore best aligns the incentives of the option holders with that of the company).
4. Vesting of options: Options are granted under a letter of grant, the form of which will usually be appended to the ESOP rules. Those options will vest progressively in accordance with a vesting schedule. Option holders may only exercise an option during the period after it has vested and before the specified expiry date (see point 5 below).
Vesting schedules vary for each company but in Southeast Asia, as is common in Silicon Valley, the period is often 4 years with a one year cliff. This means that after 12 months, 25 per cent of the options immediately vested, with the remaining 75 per cent progressively vesting, on a monthly or quarterly basis, over the next 3 years.
5. Expiry: You will want the rules to provide that any unexercised options will lapse after a certain period, often 5 to 10 years from the date of grant.
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6. Existing shareholders’ agreement: ESOP rules are often used in conjunction with a shareholders’ agreement and constitution that include important provisions when potentially dealing with small minority shareholdings, including pre-emptive rights (rights-of-first-refusal) on share transfers. As a condition to the issue of any shares on the exercise of the options, option holders should be required to execute a deed of accession to any shareholders’ agreement in place at that time.
7. No transfer: Options are personal to the relevant holder and your ESOP rules should state that they are not transferable without the approval of the board.
8. Cancellation of options: You will need to consider what happens if an option holder ceases to work for your company. Generally speaking, on departure, option holders retain their vested options, which they must then exercise within a short period of time. Unvested options will be forfeited.
The exception to this is where the option holder has left in circumstances where he or she is considered to be a bad leaver. For example, where an employee is dismissed for gross misconduct. This may result in the holder losing all vested and unvested options. Plus the company may also have a right to repurchase any shares which have been issued to that person at the exercise price.
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9. Acceleration of vesting: Your ESOP rules will need to address what happens to the options if your company undertakes a liquidity event (which essentially means it is sold, it completes an IPO or is involved in some other change-of-control event). The starting point is that 100 per cent of unvested options will generally vest on the occurrence of a liquidity event so that option holders have the ability to fully participate in that event. However, some companies like the idea of partial acceleration.
The thinking here is that an acquirer of your company may want some of the unvested options to continue to vest post-acquisition as a means of continuing to incentivise those option holders that are being taken on by the acquirer.
Practically, it is unlikely that your existing scheme will be continued in its current form following the liquidity event. Therefore if you do want partial acceleration, the ESOP rules should be clear that option holders will receive the benefit of an equivalent incentive scheme in the acquiring company.
10. Cash settlement: If there is a liquidity event, you will want the choice to cash-settle some or all of the options by paying an option holder the difference between the value of a share (as determined by the liquidity event) and the exercise price payable for each option. This will speed up the mechanics of settlement.
11. Restriction on transfer of option shares: ESOP rules typically state that no shares issued on the exercise of any of the options may be disposed of by a holder unless the board has approved that sale.
12. Drag-along rights: Your company shareholders’ agreement (to which all option holders who have exercised some or all of their options will be bound) may contain drag-along rights – which typically enable a specified majority of shareholders to force minority holders to sell their shares in the company on receipt of a third party offer. In any case, drag-along rights are commonly included within the ESOP plan so that option holders cannot block a sale where a supermajority of shareholders are in favour of the proposed exit.
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Lee Bagshaw is a corporate lawyer at technology law firm Simmonds Stewart. He advises investors and start-up companies on venture capital and tech M&A transactions across Asia Pacific.
The views expressed here are of the author’s, and e27 may not necessarily subscribe to them. e27 invites members from Asia’s tech industry and startup community to share their honest opinions and expert knowledge with our readers. If you are interested in sharing your point of view, submit your article here.
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