Investor-backed, high-growth companies traditionally offer employees the opportunity to own company stock. Employee ownership can align employees toward valuation growth, and gives cash strapped growing companies a way to compete for talented employees. For the employee founders of the company, stock is issued at or near incorporation. For employees that join later, the typical way to offer equity ownership to employees is through an employee stock option plan, also known as an equity incentive plan, an employee stock ownership pool, or simply an ESOP.
An ESOP itself is a set of written plan documents, adopted by the company’s board of directors and stockholders, that describe the basis on which a company will follow when issuing stock to employees, consultants, board members, advisors and other service providers. Among other things, these documents create a “pool” of shares that are set reserved for this purpose, describe the different ways that stock can be issued from that pool, and the terms and conditions surrounding the issuance.
An ESOP usually allows for the issuance of stock directly, for cash or in consideration of services to be rendered, or stock options, which give the recipient the right to acquire stock in the future at the price at the time of grant. Either way, the shares that are reserved under the ESOP are not outstanding when the ESOP is created. Until they are actually issued from the pool, as stock directly or upon the exercise of an option they are simply shares that could be issued in the future.
When stock or an option is awarded from the ESOP, the number of shares available for future issuance from the pool is reduced. Later, if those shares are repurchased, or, in the case of an option, the option is canceled or terminates without having been exercised, the number of shares available for issuance from the pool is increased.
Although options issued and shares available for future issuance under the ESOP reserve pool are not outstanding, they are often included in the total capitalization of the company. When investors refer to “fully-diluted” ownership, they are talking about ownership that includes both shares actually outstanding and the ESOP reserve pool. Since the size of the ESOP reserve pool should approximate the number of shares that a company intends to issue in the near term, the “fully diluted” shares number captures a fuller picture of the true ownership of a company.
Providing equity ownership is obviously not the only way to compensate service providers or align the interests of employees and investors. Broad-based equity ownership also creates challenges, and does not fit every company culture, vision or values. However, if employee equity is right for your company, it is important to do it right. Creating an ESOP will require a collaborative effort from your founders, board of directors, investors, and third-party tax, accounting and legal advisors. There are also numerous complicated state and federal tax and securities regulations and filings required —something an attorney can manage and oversee.
Inceptiv Law
Inceptiv Law provides innovative solutions to investor-backed companies. Whether your company is launching, growing or selling, Inceptiv Law’s experience can be your most significant advantage. We are accustomed to advising and supporting numerous software, life sciences, professional services, biotechnology, and other investor-backed companies. For more information, contact Inceptiv Law to schedule a consultation.
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