ESOP made easy

Simon Malpas raised $6 million last year in a seed round for his Auckland startup Kitea Health, which is working on the world’s first implantable long-term brain pressure sensor.

He intended to introduce an employee share ownership plan (ESOP) at the same time as raising the investment, as he had in his previous two companies. “All the investor groups that I had spoken to expect that there will be some level of ESOP,” says Malpas. 

The aim of ESOPs is to provide a way for startups, which need to conserve cash, to reward and retain staff, advisory board members and directors. 

“When you have clinical advisors, in our case, to pay them out of hard-earned cash is not a good idea so to bring everyone on the same waka is what it’s all about.” 

For guidance, Malpas attended a bunch of online forums on setting up an ESOP, and angel investor Scott Gilmour handed him a straightforward template he’d used years ago with one of his own companies.

Law firm Kindrik Partners is one that offers a free template for setting up an ESOP, but founders will still need legal advice to implement one. Auckland partner Julie Fowler advises “to keep it simple and don’t try to reinvent the wheel”, given the terms that are applied to ESOPs are fairly vanilla.

Luke Smith is CEO of Orchestra (owned by Snowball Effect and serial entrepreneurs Casey Eden and Shane Bradley) which helps startups administer their ESOPs and provides a portal for employees to check on their shares’ status.

Smith says there are three key reasons founders offer employees a stake in their business: studies show employee engagement and retention are higher where an ESOP is in place; it can boost company performance and productivity; and ESOPs can support the proactive culture that early-stage companies want to drive.

“When you’re inviting your employees at the early stage as owners, what you’re saying is ‘hey, you belong; you’re part of the fabric here’. There’s that ownership mindset that you’re giving to employees,” says Smith.

The first thing he advises startup founders to do is really understand why you want an ESOP.

“Does it have a strategy around it? And know your ‘why’ because there are different types of share schemes that you can apply and you can be flexible around the settings you apply to your specific share scheme.”

The right terms

Once you’ve decided to introduce an ESOP, what steps do you need to take?

An informal survey of 21 Kiwi startups last year by Melodics chief operating officer Jean Xin found almost all (90 percent) used options but just over half handled their schemes in different ways, including determining allocations for non-executive employees. 

Smith says most startups use ESOPs because they’re typically not making any profit and are ploughing any money made back into the business. Therefore, they can only really offer employees options where the potential benefit is the valuation increase over time.

Under an ESOP there’s no upfront cost to the employee. They only pay for the options after they are vested to them (granted to them at regular intervals) and they exercise and pay for them (have the shares actually allocated to them).

Smith says one of a plan’s key settings is how much of the company’s shares will be issued to participants; anything from 5 percent to 15 percent of the total share pool is typically used in early-stage companies.

In Kitea Health’s case, it has set aside 6 percent for its ESOP – a bit lower than the standard 10 percent.

“That’s only because we have quite a large founding group that all have shares, and our initial hires in terms of new employees outside of that founding group was going to be quite small,” says Malpas.

“To my way of thinking you put so many shares into your ESOP scheme and then you really have to apply them or certainly allocate them before the next investment round, otherwise the only people that gain are the investors.”

Then there’s ‘the dance’ between who is allocated shares and how many each will get, says Smith. Founders have to determine whether the scheme will be based on allocating a set amount to all staff or just key hires, and a model based on a multiplier linked to salary for the role or negotiated each time.

“[It’s deciding] how much do I need to allocate based on the seniority of those roles and ensuring that you’ve got enough headroom in your ESOP pool or the amount you’ve set aside through the scheme to cater for future hires.”

He says it’s best to have a transparent, standard setting for allocations to avoid “the water cooler conversations”. 

Malpas says the stake has to be a “meaningful contribution” to achieve its purpose. “ For example, someone on a $100,000 annual salary that is granted $50,000 worth of shares would  go “oh, that’s bloody good” whereas if you gave them $5,000 worth they might say ‘oh, that’s nice’ but it won’t retain them if offered an extra $5,000 somewhere else.”

But he doesn’t think shares should be handed out for simply turning up for work. “We’ve still got allocations to make as we’re targeted towards milestones and we’ve got a massive milestone coming up with our ethics application and getting the first patients in. That’s a really significant milestone that the team is all working hard to achieve.”

"We’ve still got allocations to make as we’re targeted towards milestones": Simon Malpas

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The valuation question

The other puzzle piece is determining the option exercise price, which determines how much employees have to pay, based on a company valuation.

Options are earned over time, with a typical vesting period of three to four years. Some companies introduce a ‘cliff’ – usually a one-year period that the employee has to work before the options start vesting. “This is where the retention lever really kicks in for employers. It’s protecting employers from granting and then employees leaving with ownership in the business,” says Smith.

Sometimes the vesting period is linked to performance milestones or when the company hits a certain valuation.

Another key consideration is what to do when an employee leaves the business or the business has an exit event, such as a trade sale or public listing. While it’s rare in startups to have an exit before options are vested, sometimes late joiners to the ESOP can still be in the throes of earning them.

Kindrik Partners’ Fowler says some ESOPs include a term, though it’s less commonly used, which gives the company the right to buy back shares granted to an employee if they leave. “In my view, it takes away the benefit of the option, which is a little bit like a lottery. If you’ve exercised your option you probably want to be in the company for the long haul, but this does give the company the ability to clean up the cap table.” 

All of these settings go into the scheme’s rules and have to be approved by the company’s board. Employees have to sign a legal document that includes those rules when they’re invited to join the ESOP.

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Too confusing?

The legal jargon used in ESOPs can make it hard for employees to understand the value of shares, so education is a big part of introducing such plans, says Smith, or they won’t have the intended impact.

Orchestra has a presentation template that startups can use as employees onboard. The presentation specifically explains how the options plan works so employees understand how their contributions to the company benefit the plan.

When Melodics’ Xin moved to New Zealand from Silicon Valley she was surprised to see how many different ways ESOPs were structured in New Zealand and how little they were understood and valued by staff. In Silicon Valley ESOPs are commonplace and fairly consistent, which make them a powerful recruiting and retention tool, she says.

Last year she wrote a three-part LinkedIn blog series on ESOPs to spark debate on what best practice would look like in this area and a standard way of setting the strike price.

Melodics founder Sam Gribben introduced an employee share scheme  (ESS) in 2014 when he set up Melodics, which sells a desktop app that helps people learn an instrument. After the IRD introduced tax changes in 2018, it morphed into an ESOP.  

The difference between the two is that under an ESS employees acquire shares directly either by grant or purchase while an ESOP grants employees the right to purchase shares at a predetermined price at a later date.

“He felt really strongly that for the people who actually built it into what it is, they should share in the upside and the intention was also then to create more of an ownership mentality around it. The intention is if we make it really big, the early people and the really key people will make it rich and then other people will have something to walk home with as well,” says Xin.

Her options were a key point of negotiation on the COO’s overall remuneration when she joined the company after coming from an environment in the US where equity is well understood. “There was no way an early startup was going to match the cash compensation I had previously been making but I had the personal flexibility to take a bit less cash and see an upside from any of my work.”

She’s had “shockingly little negotiation” on share options when hiring key executives for the company compared to haggling over the cash components. “There haven't been enough exits in New Zealand yet to see big money from ESOPs. But once we start getting a few, and people start to see [the upside], people will care a lot more.”

"The intention is if we make it really big, the early people and the really key people will make it rich and then other people will have something to walk home with as well": Jean Xin

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The taxation situation

The Startup Council’s recent report to the Government identified taxation of ESOPs as a big challenge for startups.

Although New Zealand doesn’t have a capital gains tax, employees are currently taxed when options are exercised and paid for, rather than on-sold by the employee. The tax due is assessed on the difference between the option exercise price and share’s market value. It has meant employees end up paying for a non-cash gain that may or may not eventuate, especially if the startup ultimately goes belly up.

Xin says you’re expected to pay tax on an option even when you haven’t made any money off it and “by the way, the vast majority of them, their value will go to zero so it feels like it’s unreasonable to be taxed on that”.

Some schemes simply allow the vested shares to be held longer by the company and not exercised until a liquidity event, when the tax would be applied.

The other problem is that startups have to assess the underlying value of their shares each time an option is exercised, which could involve an expensive third-party valuation. There’s little guidance from IRD on what it will accept as proof of value at the time of exercise.

The Startup Council recommended exempting startup ESOPs from tax altogether but included a fallback position that the tax should be deferred until employees ultimately sell and make a gain, rather than when they exercise the options.  

Orchestra’s Smith thinks a better option would be for New Zealand to match Australia’s startup employee share scheme tax concession. Under that scheme, introduced in 2015, employees don’t pay tax until their shares are sold, at which point the capital gains tax rules that apply to all assets come into play. Providing the startup meets the criteria, a 50 percent capital gains tax discount applies to the employee if the sale occurs more than a year after the options were granted. 

“In my personal view, that’s quite a nice solution,” says Smith.

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