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How to Establish an Employee Stock Option Plan

Jonathan Selby - Founder Shield
Jonathan Selby

General Manager

It’s not challenging for high-growth companies to create their employee stock option (ESO) plan — but only with the right tools and upfront investment. During this process, any difficulties or violations of regulations can create severe mishaps for founders and their board, including fines and legal exposure. So, here’s how to start on the right foot.

Understand Employee Stock Option Plans 

An ESO is a type of equity compensation provided by companies, and this financial incentive allows employees to share directly in the success of a company’s growth. Startup companies often issue stock options to reward early employees if the company goes public. Other fast-growing companies use them as incentives, so employees work towards amplifying the value of company shares. 

Essentially, with ESOs, employers offer derivative options on the stock instead of giving stock shares directly. This approach gives employees the right to buy company stock at a fixed price for a specified period.

When a stock’s price rises above the option exercise price, the employee gets the company’s stock at a discount. They can choose to sell the stock in the open market or hold onto it.

There are two main types of ESOs:

  • Incentive stock options: ISOs, known as statutory or qualified options, are often only offered to top employees and management. These employees can purchase company shares at a discounted price with the benefit of potential tax breaks on the profit. If they wait at least two years after being granted the shares, they’ll be taxed for long-term capital gains instead of short-time, leading to hugely different tax rates.
  • Non-qualified stock options: NSOs aren’t just for employees but investors, partners, and vendors. Known as the non-statutory stock option, NSOs don’t allow workers to have favorable tax treatment; it flows through to the Wage and Tax Statement as ordinary income tax.

Pro Tip ↓

To learn more about tax credits, read this: Valuable Tax Incentives & Credits for Your Startup

Be aware: ESOs often get confused with Employee Stock Ownership Plans (ESOPs), set up as trust funds. The primary difference is that an ESO is a compensation plan and employee benefit, whereas an ESOP qualifies as a retirement plan, such as a 401(k). With an ESOP, employees don’t purchase shares with their own money, while ESOs allow employees to use their money to buy company shares at a discounted rate.

Know the ESO Benefits for Both Companies and Employees

Our most valuable assets are our employees, our people — but they are jumping between jobs faster than ever amid the Great Resignation. Therefore, retaining top employees is the top priority for businesses across the board. 

ESOs aren’t only a cost-effective recruiting tool when the competition for talent is fierce. There’s also a clear relationship between granting these stock options and retaining employees long-term with profit-maximizing behavior. ESOs really boost employee satisfaction and financial well-being, and with a stake in the company, employees feel more motivated to support company growth. 

Stock options also protect employers by requiring an employee to work with the company for a specific time before they can receive access to their stock options. This approach shields the company’s equity while limiting employee turnover.

Plus, ESOs offer a potential exit strategy for owners looking to sell their company but wanting to retain business continuity. By selling the company to employees, owners can almost choose their buyers and leave a legacy for their loyal workers.

Get to the Nitty-Gritty of Setting Up an ESO 

The first step is to develop the ESO’s philosophy collaboratively with the founders, the board, and advisors. Then, using your company’s mission and values as a base, you’ll have to: 

  • Discuss how to communicate this ESO incentive to future employees. 
  • Determine how much of the company will be shared with early employees and those who join later.

After getting approval from the board on these pointers, you can start sorting a plan. Perhaps you’ll sell your stock grants in shares of 100 or allocate them differently? Get it written down. Also, speak with your lawyers to ensure you have the necessary permits to comply with state and federal regulations.  

The biggest challenge businesses face with equity compensation is clearly communicating the benefits to employees. So, the rollout could include using a digital platform with employee access to building a culture of ownership. Passive employee stock plans have already been proven to help with employee retention, but imagine the increased value when there’s an added layer of engagement.

Maintaining the ESO

Assigning someone in the company or having an equity management software program to manage your cap tables per Internal Revenue Service (IRS) guidelines is essential. The right capitalization table software could prevent costly mistakes due to manual errors.

If you use a reputable valuation company, the IRS will give you positive marks for valuing your stockholders and employees. Always be aware of when you need a new valuation, too: If your valuation is over 12 months old or you reach a significant financial milestone, get a new one ASAP. 

A common mistake companies make is underfunding their equity budget and compensating new employees, which can expose your business to legal liability. So, make sure your hiring team is on the ball with the equity budget. The hiring plan can determine the number of stock options you need for new employees. Look at the stock option allocation regularly to ensure it will support future hires, and immediately take it to the board if there’s a shortage.

Making ESO Offers

At Founder Shield, we’d recommend working with a well-versed attorney and experienced accountant to assist with confirming employees’ residency and work visa status before you make them an offer, reducing the likelihood of problems later on down the line. There are a few other things to check off too: 

  • Declare the type of stock options employees will receive (ISOs or NSOs). 
  • Explain the value in terms of the number of shares rather than the percentage of the company. 
  • State that the board must approve all stock option grant amounts before the offer letter becomes valid.  
  • Make sure employees understand any tax implications associated with their equity compensation.
  • Remember to deliver a final, executed copy of the agreement to employees.

Consider the ESO Legal Issues

Company directors and officers have a fiduciary responsibility to their employees and shareholders, so it’s vital to establish a clear outline of the ESOs in your company’s employee handbook

Then, update your Employment Practices Liability (EPL) insurance for your entire employee pool — it’s just as crucial for on-site employees as remote workers.  

And finally, review your Directors and Officers (D&O) insurance that covers and protects your leaders’ personal assets and the company itself from claims, including those related to retention insurance. The allegations against directors and officers run rampant nowadays; however, most cases stem from mismanagement. 

There are three layers to D&O insurance worth reviewing:

  • Side A: If a director is individually named in a suit and forced to pay defense costs and settlements, this portion of D&O insurance kicks in to protect the individual. But Side A will only pay the individual directors if the company is unable or unwilling to indemnify the individual. This could be because the company is insolvent or the claim goes against the company’s bylaws.
  • Side B: When the entity indemnifies individuals named in the lawsuit, Side B coverage reimburses the costs. However, it only extends to compensating insured individuals named in the lawsuit.
  • Side C: This coverage provides balance sheet protection for the company named in the lawsuit alongside an individual executive. Side C coverage will reimburse the costs and settlements incurred.

ESOs are complicated, requiring administrative, legal, and compliance costs, with many potential pitfalls. That’s why understanding what coverage your company needs and what risks your industry faces is essential. At Founder Shield, our mission is to create a seamless, intuitive, and responsive insurance process to protect your company’s growth every step of the way.

Want to know more about commercial insurance? Contact us at info@foundershield.com or create an account here to get a quote.

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