Getting to grips with granting startup options
An option pool is a key tool at a high growth startups disposal to attract and retain top talent. This post sets out some of the key concepts that founders should consider when thinking about granting options to employees.
What is an option?
Options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. In our case we’re focused on the right to buy a set number of shares at a specified price on or before a defined date. The price is often referred to as the “strike price” and refers to the price set on the date the options are granted. In successful startups, options can become very valuable as the fair value of the shares in the company increases significantly beyond the strike price.
Why do startups grant employees options?
There are a number of key reasons for startups to grant options to employees:
(1) Alignment of interests – options allow employees to share in the success of the startup (alongside its founders) and potentially provide an additional incentive for an employee.
(2) Economic / pay – options also provide a mechanism by which startups can fill the gap between what an employee could earn in the market and what a startup is able to pay. For example, an employee may be able to earn £100k working for a large tech company with an additional very small option package (or none at all) whereas a startup may not be able to match such a salary but is able to offer a potentially more generous options package.
(3) Retention – most option packages are on a vesting schedule and/or be subject to leaver provisions (all Seedcamp and other VC backed companies will include vesting in their ESOPs). Therefore, employees who receive options will be additionally incentivised (in positive situations) to stick around to gain the maximum benefit.
(4) Tax and governance – when considered in comparison to issuing shares to employees rather than options, options have the benefit of potentially being more favourable from a tax perspective (see below). Also if shares are issued the employee would become a shareholder in the startup and inherit certain rights (i.e. dividend, information, voting) that may not be appropriate.
How many options should the first employees get?
This is a common question that comes up regularly with the companies that I work with. There’s no magic formula and often the answer is the incredibly frustrating “it depends”. The process is often described as more art than science and it’s very difficult to point to an exact way of answering the question.
There’s some great posts out there going into more detail on the topic so I’m not going to dwell on this here but I’d recommend reading these to get an overview of methods to arrive at amounts for individual grants broken down by roles:
And these posts looking at the evolution of option pools over numerous rounds are worth checking out:
A key point to note, that my colleague Carlos flags in his post, is the importance of being clear with what % the grant is in relation to. It’s important to highlight that the % is in relation to the current fully diluted cap table (at the date of the grant).
eShares have a great example of how they explain employee equity to new hires in their offer letter – in this, they clearly set out the scenarios and what such a grant could be worth to the employee. Buffer famously also include a full transparent breakdown of how they calculate option grants and the factors and variables they take into account — more on that here.
How do startups grant options?
Once the total pool size and breakdown has been determined the process needs to be properly documented. Getting the paperwork right is crucial to avoid complications down the line.
For UK companies, generally, the first thing required is to get an Employee Share Option Plan (ESOP) written up and approved by the startup and its board. Such a plan requires careful drafting and advice from a specialist tax adviser and/or lawyer. Most UK startups go down qualifying their ESOP under the Enterprise Management Incentive (EMI) route. The major benefit of this approach is that it potentially means there is no income tax payable by employees when exercising their options — only on the gains on an exit (where Capital Gains Tax (CGT) will be payable). This is a significant potential tax benefit for employees. Before any option grants are made it’s necessary to get a valuation of the startup done. Such a valuation for an EMI qualifying ESOP is different from that referred to at a funding round (where it’s set by third party investors (VCs, Angels etc.)) and in this case actually requires an application to be made to HMRC. Care needs to be taken with the application and advice should be sought from a specialist accountant to assist. Obtaining a low valuation for the purposes of pricing the options (strike price) is generally seen as preferable because it will maximise the potential gains and therefore the impact of the grant for the employee (as such it’s helpful for hiring purposes). The valuation will only be valid for a set period of time (~60 days or so) so it’s important to make the option grant shortly thereafter. It’s worth noting also that options granted under the EMI route only qualify if made to employees. Once all the paperwork has been approved, finalised and signed by startup and employees the option grants need to be filed with HMRC (within 3 months) to qualify for the tax advantage.
The market for options in Europe
Overall I don’t think there’s enough value given to startup options in Europe. Perhaps this is down to the risk tolerance of us Europeans and our tendency to favour a certain salary over equity. I’d like to see European startups be more aggressive with their option grants and spend more time educating employees as to the potential value that such option grants could present. It feels like there’s value being left on the table there. The US market appears to be ahead in this regard probably buoyed by the fact founders there can point to more success stories of startups scaling to exit. For any startup, one thing is for certain, talent is absolutely critical and therefore spending time devising a strategy around how options can be used to attract and retain world class talent is time well spent!
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It goes without saying that ESOPs are a complex area and advice should be sought from a qualified account and/or lawyer to ensure all the proper steps are taken. Also to note, the above is meant only as a quick summary and there are some other points to consider such as: eligibility criteria and a maximum amount that can be granted (the full criteria can be found here).
Originally posted on Medium.