What is an ESOP? Everything you want to know about Employee Share Option Plans explained
As recruiters, we are facilitating more and more conversations between clients and candidates about the gaining popularity of Employee Share Option Plans or more commonly known as… ESOPs. We often get asked, how do they work? What even is an ESOP? Why should candidates care about ESOPs? So, we’re here to answer all your questions!
ESOPs are a relatively new concept entering the workforce, and it’s understandable that you want to do your research before you add an ESOP to your company. Put simply, ESOP is an employee benefit that provides employees with an ownership interest in the company in the form of shares of stock. ESOPs are seen to improve employee morale, productivity and ‘buy-in’ (pun intended) by giving them a direct interest in the value of the business. Long story short, ESOP is engaging an employee beyond their salary by giving them some form of skin in the game.
Hi Yotam! Thanks for having this chat with us. To start, tell us a bit about you and Digital Surge?
I was the Co-Founder of Earbits (now You42) a US-based music startup that was funded by Y-Combinator. In 2017, after Earbits’ acquisition, I moved to Australia and took on a role as the EiR (Entrepreneur in Residence) at QUT Bluebox.
At Bluebox, we funded 10 startups twice a year and took them through a 3-month accelerator program. In 2019, one of these companies was Digital Surge. At the time, it was still a side project of Josh Lehman and Dan Rutter, but by late 2020 they relaunched the platform and experienced exponential growth. They needed help and I was excited to shift back from advising founders to getting my hands dirty, so I joined the team.
How did you end up working with Hunt & Co.?
One of the startups I mentored through the iLab program, Bloom Impact Investing, highly recommended Hunt & Co. I reached out when we were searching for a Marketing Specialist. Holly Hunt and her team were friendly, professional, and quick to introduce us to the perfect candidate.
Side note: If you are interested, you can learn more about Bloom in our Q&A with the Founder of Bloom, Camille Socquet-Clerc here.
For someone completely new to ESOPs, what are they and how do they typically work?
ESOP stands for Employee Share Option Plan. In simple terms, it allows the employer to grant the employee options that they can exercise at a future date for shares in the company without upfront cost or tax complications. An employee with a stake in the company is far more likely to stick around for the long haul and to be highly motivated to contribute to the success of the company because if the company succeeds there will be a financial upside for the employee. An example of that may be an acquisition or an IPO.
Stock options are optional and are included as part of the remuneration package. The options are typically not given in full straight away but instead, they vest over time. A typical vesting schedule is 4 years with a 1-year cliff. The term option is used because the employee gets the option to exercise the option to buy the shares. However, the cost of the shares is determined by the value of the company at the time the employee comes on board. Let’s illustrate how it works with an example:
Kate’s package includes an annual salary of $120k plus Super, plus 0.5% in stock options. She is joining a relatively new startup and the valuation of the company is $1M. If Kate leaves her job any time before her first anniversary with the company, she will walk away with zero options for equity. However, as soon as she reaches that first anniversary, she will cross the ‘cliff’ and be granted ¼ of her total options allocation (0.125% in this case). From there on, with every month that Kate stays with the company, she will earn, over the course of 3 years, the remaining ¾ of her allocated options. Fast forward 4 years, Kate now holds 0.5% of options. At the same time, the company is being acquired for $100M. Kate can now choose to exercise her options to purchase 0.5% equity in the company at the strike price from 4 years ago, which is $5,000 (0.5% of $1M). As soon as the company gets acquired, she will be rewarded with $500,000 (0.5% of $100M), reflecting the new and much higher valuation of the company.
One caveat to keep in mind is that whenever companies raise capital, they typically end up issuing more equity, which means all previous equity and option holders get diluted. In the example above, it’s likely that the company would have raised two rounds of capital and with each round, Kate’s share would have diluted by ~20%. This means she will end up with 0.032% translating to $320,000 in payout.
Why should candidates care about ESOPs?
Without ESOP the employee has no future financial upside. It can be quite disheartening to help build something of great value and not be able to reap the fruits. Most people focus on negotiating their salary because that is the most immediate financial outcome of a job. But if you find a job with a company that you like and believe in, you should ask yourself what kind of financial outcome you wish to see from being with this company in the long run. What may sound like an insignificant amount of equity early in the lifetime of a company can become extremely meaningful over time. Imagine having a 0.5% stake in Go1, a Brisbane-based startup that just recently was valued at $2B. That 0.5% stake is now worth $10,000,000.
Thank you Yotam for talking to us about the exciting world of ESOPs!
Here at Hunt & Co., we are a boutique recruitment agency driven by our purpose to make life-changing connections. We do this by helping organisations hire high-performing teams and helping individuals find their next career move. Whether you are building your team, looking for a new role or just want to know what the market is doing, get in touch with one of our wonderful Recruitment Consultants today! Click here for our Contact Us page or email firstname.lastname@example.org
Disclaimer: Hunt & Co. and Digital Surge are not financial advisors. Please consider seeking independent legal, financial, taxation or other advice to learn more about ESOPs and how it relates to your unique circumstances.