How to Set up Employee Stock Option Plan (2024)

We invited the CEO, and co-founder of Outlier AI to share about his experience on a recent webinar. This article is an insightful reflection of our conversation and an opportunity to share our learnings with founders to help them set up an effective ESOP.

Today, Sean serves as the CEO of Outlier, Inc. - an up-and-coming startup in the business intelligence space. He has already experienced a great deal of success over the last 20 years he has worked in technology, but when you ask Sean what it’s all about he shares a clear vision.

“People become founders for many different reasons,” explains the two-time tech founder. “Some people want to get rich, some want to become famous. But for me, it was enough to create a place where people wanted to work, where they really enjoy their time at, where they felt rewarded and respected as a person and that’s been a guiding principle over my whole career.”

As altruistic as this may sound, Sean has experienced a lot of business success by developing a company culture that gives workers a sense of belonging and empowerment. “I have hired hundreds of people across my companies, and I’ve made some mistakes,” Sean explains. “But one thing that I think is true is that, as long as I’ve had this guiding principle of treating employees with respect and looking out for their best interests as well as I could, it turns out you can do quite a lot.” This includes top talent attraction, retention, and differentiation of your company in a competitive marketplace.

One way that Sean looks out for his teams’ best interests is by offering equity and ownership options. This may seem complicated, but it’s not as difficult as you might think. We covered the fundamentals of employee stock ownership options in a previous post, but let’s take some of Sean’s advice and take a deeper look at employee ownership options.

‍ACHIEVING EMPLOYEE OWNERSHIP

Employee ownership can be achieved in many ways. The ESOP, or employee stock ownership plan, is a common form of employee ownership. It ensures that the plans benefit employees fairly and comprehensively.

If you've determined that an employee stock ownership plan (ESOP) is worth investigating, there are a few procedures to follow. As Sean says, "you can hire the best people, and you can retain the best people, and they will do their best work because most companies don't take the time to learn about employee stock option plans and how to make sure you protect your employees."

We'll go over the most common mistakes founders make when launching stock options: using the standard stock option plan that most startups use. Then, we'll go over how to structure employee stock options; the three different ways you can give them to employees; and examine the Outlier AI story to back up our insights with success stories.

WHAT TO CONSIDER BEFORE OFFERING STOCK OPTION

When setting up a stock option plan, you want your employees to have equity. Part of the benefit is to have structures where employees have equity and ownership so they own part of the future of the business. And that's a good thing. They’re invested in the company’s progress. It may be a long-term incentive because employees must wait until the company exits to get a return. But that long-term incentive is a great way to unify everybody's focus and solidify employee support for the business to succeed.

But if you think about it, the first set of employees you hire will have a meaningful impact on the business. You likely will want them to own more equity. Think about ways to build loyalty and reward retention in building out your standard stock option plan.

BUILDING YOUR STOCK OPTION PLAN

The standard stock option plan grants your employee a stock option that invests over four years. After the first year, there's a cliff—they don't own anything for their first 12 months, but after their first year, they invest in 25% of all the options you give them. After four years, they can invest in a 100% of the stock options available.

Another part of the standard stock option plan is that if the employee were to leave the company for some reason, they have 60 days to exercise their stock options. However, what happens if that option disappears?

For example, you were offered the option four years ago at 10 cents. Four years later, it could be $10. If it's $10, you must pay taxes on the difference, which the amount of tax can be sizeable. In turn, employees cannot afford to exercise their options because they can't afford to pay the taxes. Rather, they would owe money due to them, which creates a very negative dynamic. Employees will leave eventually, but they can't exercise their options and let them go.

Another problem is that most people cannot afford to leave the company because their exit would mean they would have to return their equity and have gained nothing.

"And those sorts of situations, you can think about how much stress we go through as a startup, how much effort and how much work and all those things go into building the business and how hard it is. And so that was a mistake that I made, kind of an issue that, you know, I still regret, but there are solutions that we can talk about in a second about Outlier and what we've done differently to address it."

THREE DIFFERENT WAYS YOU CAN GIVE TO EMPLOYEES

Restricted Stock Purchase - Employees in restricted stock plans have the option of purchasing shares at fair market value or a discount, or they may receive shares at no cost. Employees' shares, however, are not yet truly theirs. They cannot take possession of it until certain restrictions are lifted.

Stock Options - Employee stock options are the type of equity granted to executives and employees as part of a compensation plan. This plan is created by the founding team that reflects the conditional equity allocation for everyone.

Restricted Stock Units - A Restricted Stock Unit is a grant that is valued in terms of company stock but is not issued at the time of the grant. The company distributes shares, or the cash equivalent of the number of shares used to value the unit, once the recipient of a unit has met the vesting requirement. Depending on the rules of the plan, the participant or donor may be given the option of settling in stock or cash.

COMMUNICATING STOCK OPTIONS WITH STAKEHOLDERS

“It is surprising how few companies will sit down and explain how options work, such as vesting periods and what may happen if an employee leaves too early,” Sean explained during our sit-down. “Employees will find your company more interesting and more attractive because you have been so transparent about how you handle employee stock options.”

Ownership in a company isn't only about the shares. It is knowing how the company is operating, progressing, and growing. So, if an employee joins your company on day one and you failed to tell them about the share price, stock options, and the likelihood of the stock options increasing over time. Do the employees feel ownership in the company, even if the value their stock options is increasing? If you don’t inform them properly about employee stock options, it will appear simply as a number on a stock option agreement.

"Just because somebody has 10 years of experience, you shouldn't assume that they know how these things work, because nobody might've explained the intricacies, the nuances of them."

One of the advantages of being a founder is that you're making these decisions. You can share them with your employees so they can understand how stock options work. If you explained the reasoning behind your decision-making and the employee stock options work, you will help everyone succeed. Founders of companies can continually building trust and transparency with their employees and how the equity they have is becoming more valuable over time. The best way to start this process started is even before the company is founded.

HOW BIG SHOULD BE THE STOCK OPTIONS BE AT THE BEGINNING

There is no steadfast rule about how much you give to employees in stock options. When you get to the later stages of the company, such as when you raise a series a or series B, there are industry benchmarks that will guide you on how certain positions should own at least this amount of your company.

But with early employees, the general philosophy is that you should be as generous as you possibly can. Fortunately, you can change this policy at any time. Changing stock options amounts only becomes an issue when you raise venture financing, because now you must have the approval of your investors to change the size of the stock option pool. Usually, investors want your company’s stock option pool to be as vast as possible so that stock ownership is diversified and not concentrated in the hands of a few investors.

You may need to consider this aspect when issuing stock options. So, if you were to get a term sheet from a venture investor, one of the areas of negotiation that's most common is that they want you to create a large stock option pool even before they invest whereas you may want to have a small stock option pool. You will likely have to negotiate these stock option pools in order to reach an agreement with the investors.

One of the most common areas of negotiation is the stock option pool because it determines how many people can own a certain amount of stock options. Would the stock options be limited to the founders of the company only, or would it be the founder of the company and the investors? Would it be a combination of the founder, investors, and some employees? These scenarios will need to be negotiated in order to find the best path forward for designing the employee stock options plan for your company. For more information on this topic, check out our other resources on Employee Stock Ownership options.