Want to know all the ESOP terms? Here’s a nice cheat sheet for you.
In my Udemy course called “The best guide to startup Employee Share Option Plan (ESOP)“ (Check it out by following the link at get a $5 discount) I was asked for a cheat sheet of all the key terms so students could more easily understand them. I made this to help.
Here are all the key ESOP terms you need to know. If you want to download it in a nice little PDF head click the link below!
Download the ESOP terms cheat sheet here
Video version
Here’s a video version if you prefer to watch it
- Stock / shares
- Mean the same thing, they are used interchangeably
- This is a fractional ownership of a company. A share is literally a share of a company; it confers certain ownership rights as well
- Options
- Options are different to shares
- This is the option to purchase stock. You don’t actually own shares until the options convert (exercise) into shares
- Options are the right but not the obligation, meaning a requirement to purchase stock, at a specified price (exercise price), for a specified period of time, or when the options expire, which is typically 10 years
- You exercise your options if the value of the shares is higher than the option price (i.e. the spread is greater than 0)
- Share price
- To use an analogy, in public markets this is what you can buy Google for. You just go to your broker account and you press buy, and the market has determined the price you can do so
- In private markets this is not so clear as it’s an illiquid asset; no one has made a market for it. This is typically the last price you were invested at
- In the US, with all the taxes and rules they have, they have Section 409a valuations, where an advisor charges you money on an annual basis to set a fair market valuation for your startup
- So, the share price is what your investors or an advisor think your shares are worth, until someone buys you and sets a real price per share. Before an exit, the share price in a startup is imaginary
- Exercise / strike price
- Also, known as the strike price, this is important to you employees’ upside as this is what they buy shares for (Cost of options)
- This is the base price you get when you are granted your options as an employee
- The price is the fair market value or your last valuation, depending on how it works in your country. Staff want this price to be as low as possible
- Also, known as the strike price, this is important to you employees’ upside as this is what they buy shares for (Cost of options)
- Exercise
- This is what happens when you exit. You exercise your shares
- Pay the strike price to convert options into shares at your company. At this point, there is a tax consequence. Talk to a tax advisor to understand the rules in your county.
- Exercise date
- This is the date your staff can exercise their options. It’s when you ‘exercise’. Surprise surprise. Your staff can’t sell your shares unless there is an acquisition or an IPO, in most cases. When companies get big they sometimes allow shares to be sold on secondary markets
- Spread
- Difference between the exercise price and the share price
- If the exercise price is $10 and the share price is $50, then the spread is $40
- The share price is going to be bigger than the exercise price if your staff are going to make any money
- Assuming the share price is larger, you take the spread, times it by the number of options your staff have got and they equal the profit they are going to get. If they have 1000 shares, that means it is $40,000
- Vesting schedule
- This means you get shares over time and not all at once
- Most companies vest their shares over a period of 4 years. There can be some variances, and it is up to you to decide on the schedule. Angel list, a company you may have heard of, they set their vesting schedule at 7 years which is not very common. To compensate for longer vesting schedule, the issuance staff get is larger
- You can vest monthly or quarterly. I prefer monthly, I think it makes more sense. You might think you get some benefit if you have quarterly, but it’s perception vs. reality. Staff will hang around up to two more months to get a quarter, but let’s face it, if staff have the bug and want to leave, let them before they infect other staff. You could also benefit a little at exit if you exit whilst people are still vesting on that quarter, but that’s not a great way to think
- Cliff
- A vesting “cliff” means that there is a period of time of no vesting, but when the specified time (the “cliff”) is hit, the benefit becomes fully vested
- For example, in a 48-month vesting schedule with a 12 month “cliff”, no vesting occurs for the first 12 months, but at the 12-month point, the stockholder receives full credit for 12 months of vesting. In effect, the staff has now vested 25% of the shares they were issued
- After the “cliff” is met, vesting would continue thereafter on a ‘monthly’ basis
- A “cliff” is often used with new employees. It acts as a probationary period during which the new employee has to prove himself or herself
- Maturity
- You have to define how long the exercise window is. Staff need to exercise within a defined period which is typically 7-10 years. If the options are not exercised they disappear
- Importantly, they also expire when staff quit working for the startup (e.g., 90 days after termination of service) — so can effectively be worthless if they cannot exercise them before they leave. This is a cause of contention since staff often don’t have the money to pay the exercise value and taxes applicable
- Expanding the pool
- If you survive long enough and issue shares to staff left right and centre, you will eventually run out of shares. At seed, you had a 20% pool, you made a lot of hires and now you are at series-a and need to make some big hires. You will need to make it larger to make these hires. This is called expanding the pool. Basically, means toping up your ESOP and will happen at each fundraise
- Rules
- These are all important, but less important things for you to know. You can’t transfer to them to people, use shares as a loan etc. To dig into this, watch the course or get a lawyer as there are a lot of rules you can add or remove
- Accelerated vesting
- Some founders and key executives negotiate into their equity arrangements (stock based, not options) that they will be entitled to some form of acceleration of the vesting on their equity upon the occurrence of a triggering event, which is typically acquisition
- Simply put, you might get to vest fully before the vesting schedule says so. This is not the norm, even for founders and key executives, and almost unheard of for rank-and-file startup employees
- With stock options (i.e. ESOPs), however, it is not standard to put in these kinds of acceleration of vesting provisions. Typically, only top executives will receive vesting acceleration provisions in certain circumstances
- There are two types of acceleration, single and double trigger. which simply means either one or two things need to happen to get accelerated vesting
- Single trigger vesting
- This is the best one for you as a founder. Acceleration triggered solely by the sale of the Company is called “single-trigger” acceleration, and results in some or all of the vesting restriction lapsing in connection with the sale. This is designed to reward the employee for their contribution to a “successful” outcome for the Company
- Double trigger vesting
- Double-trigger acceleration, as the name implies, requires two events to trigger acceleration – most typically the sale of the Company and the involuntary termination of the employee. i.e. being fired
- This is usually within 9-18 months after closing, and in some cases including a short pre-closing window to counter any pre-emptive termination by the Company to avoid a pay-out
- Typically, the termination means termination by the Company without “cause,” but can also include resignation by the employee for “good reason” (e.g. a cut in pay, mandated relocation to the middle of nowhere (e.g. 50miles away from current office), or significant downgrade of duties). This is like Silicon Valley TV series when Nelson Bighetti gets sent to the roof
- Double-trigger acceleration has become very popular with early stage companies and aims to align the interests of the employees, the investors and potential acquirers with 3 things:
- providing a safety net for key employees, some of whom may be removed in the consolidation during post-closing integration – CFOs are particularly susceptible for this;
- reducing dilution from automatic acceleration, and;
- easing the complaints of the acquirer by preserving the requirement of ongoing service to ‘the Company’ in order to vest. Meaning you need to keep working to get the value of your shares
- Some investors may not like this as the acquirer may then need to make a new incentive package for management, and that could come out of the acquisition price- meaning their pie gets smaller. Investors don’t care about management getting upside unless they are still in the deal and so want to see more upside
- Acquirers may also be concerned about the prospect of handing you and your merry gang life-changing amounts of Tesla money, and then trying to formulate retention packages that are sufficient to actually get you all to remain in their jobs, particularly through the ‘sometimes-difficult’ period of post-acquisition integration; a time when these employees may have new bosses and uncomfortable new levels of big corporate bureaucracy (i.e. screw this, I’m rich, why stay around!)