Two weeks ago we published our Standard Term Sheet, the first piece of our set of Investment Documents prepared in collaboration with BonelliErede.
Today we are sharing with you the Employee Stock Option Plan, commonly referred to as ESOP. This article aims at covering the most important parts of the document so that you can read through it without feeling overwhelmed by the legal terminology. As always, if you want to skip straight to the document, it’s on our website, together with a guide for employees on how to better understand it.
As a founder at the start, attracting and retaining talent should be your #1 priority (and probably that should be your #1 priority throughout the entire journey). The ESOP is one of the most powerful tools you have to do this effectively, and we’ve seen that in Europe in not super straightforward to use as it is in the US.
Our hope is that this framework will be used by many founders in the coming years to set up their ESOP plan, and that in turn many employees of future Italian unicorns will share in their companies’ success and invest in the next generation of Italian startups.
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What the ESOP actually is
An ESOP is a pool of shares set aside to be granted to the people building the company with you: employees, managers, directors, and in some cases advisors and external collaborators too.
What you grant them are not shares. They are options: the right, not the obligation, to subscribe one share of the company in the future at a price fixed today (the “strike price”). If the company grows, that price becomes a really nice bargain. If it doesn’t, nobody exercises anything and nobody has lost cash.
Why you should set up the ESOP early
One of the most common mistake I see founders make is setting up their ESOP too late. This creates many missed opportunities to attract talent because they don’t have a credible way to join in the company’s success.
A few reasons why the ESOP is so important:
Alignment. If the company grows, everyone benefits. If it doesn’t, nobody does. Charlie Munger once said: “Show me the incentive and I will show you the outcome”. If your employees are not owners of the company, it’s really hard to find people who will act like one.
Convenience. An ESOP lets you hire people you cannot yet afford to pay in cash, and it makes your offers competitive against companies that can. In Italy, under specific requirements, options are also very tax efficient.
Clarity. Once the Rules exist, the answer to “do I get shares, how many, and when” is written down, giving you a clean cap table, which is very handy at your next round.
Plus, how are we gonna make sure that when your company becomes a unicorn your employees are gonna become super angels for the next generation (and invest in super cool funds supporting that 😎)? ESOP!
The three important moments
Every stock option plan is really about three moments: grant, vesting, exercise. If these are clear in your head, you’ve already done a lot of the work!
1. Grant
The Governing Body (Board or founders usually) picks the beneficiaries, decides how many shares each can subscribe, and sets the strike price. That gets communicated in the Grant Letter, which the beneficiary signs and returns. The person needs to have an actual relationship with the company on that date.
Options are granted free of charge. They are also strictly personal: not transferable, not pledgeable, not sellable, unless the Governing Body authorizes it. And receiving options once creates no expectation of receiving more later, and no right to keep your job.
The strike price is set by the Governing Body per beneficiary, and can never be lower than the nominal value of the shares. Practically, early hires get a low strike price, later hires get a higher one, and that difference is the reward for taking a higher risk by joining an early stage startup.
2. Vesting
Vesting is how options are deserved. Our Rules leave the mechanics to the Grant Letter, which means one plan can serve very different people. Two main flavours:
Time-based: as long as you stay, you vest. This is the default for most roles.
Milestone-based: you vest when you hit defined results. Typical for sales or roles with measurable targets.
Then the modifiers:
Cliff period (usually one year). A time window in which your shares are not vesting. Get through it and you vest everything you would have accrued from day one. Leave before it ends, for any reason, and you lose all of it.
Stability period. A minimum commitment window. Resign before it ends without a just cause and you forfeit everything, vested included.
Acceleration. Not automatic in our Rules, but the Governing Body can grant it case by case. More on this below, because there is an important caveat here.
Vesting stops the day the relationship ends. No option vests after that.
My personal view is that you should be generous with equity. At the seed stage, European and US startups both dedicate around 10% of their fully diluted equity to the employee option pool (Source, Index Ventures). In situations in which you’re missing key roles (like the CTO or the sales skills if you’re a technical team) you might need to set aside even 20% or more.
3. Exercise
This is usually the part that people find a bit confusing, so bear with me!
Under our Rules, options can only be exercised when a Liquidity Event happens, and only if it happens before the Final Term (a fixed expiry date you set when you adopt the plan).
A Liquidity Event means: a sale of shares that changes control of the company, a sale or exclusive license of all or substantially all the assets or IP, a listing, or any other extraordinary transaction the Governing Body decides to treat as one.
Why exit-only? Two reasons. First, in a startup the exit is when the proceeds actually exist and the payoff becomes real and not just on paper. Second, it keeps beneficiaries off the cap table until the moment it matters, which keeps governance simple and your next fundraise clean. The exception is founders and sometimes very senior people: they are usually on the cap table already, so postponing their exercise makes little sense.
The process itself is short. Before the event, the company sends an Offer Letter with the exercise deadline, the number of shares, and any instructions. The beneficiary replies with a written, irrevocable Notice of Exercise and pays the strike price. It is one shot, in full, within the window. Miss the window and the options expire.
You should be careful about two things:
Unvested options die at the Liquidity Event. If the exit happens before someone’s vesting date, their unvested options expire automatically. No notice needed. This is standard, but it is exactly the situation where the Governing Body’s power to accelerate exists, and where I would encourage you to use it. If your team gets you to an exit two years in, the last thing you want is a conversation about why half their upside evaporated at the finish line.
Everything dies at the Final Term. If no Liquidity Event has happened by then, all options expire, vested ones included. So set that date far enough out to be realistic about how long exits actually take.
Good leaver, bad leaver
An important part of the ESOP rules is where the consequences of leaving the company are laid out. There are two possibilities:
Good leaver: The employee leaves for a “good reason”. This could be circumstances caused by the company, or health issues. In this case the employee will keep their vested options and stop vesting new ones. —> There is no reason to punish someone who leaves for legitimate reasons.
Bad leaver: The employee gets terminated for just cause, or for acts that harmed the company. In this case the employee will lose everything, vested options included. —> Someone actively working against the company’s value has no claim on its upside.
You will notice the Rules leave both definitions blank, to be negotiated. That is on purpose. Almost every other clause in this document is market standard and not worth your energy, but the leaver definitions are genuinely worth sitting down and writing precisely, with your investors and your lawyers, before you hire.
Closing note
I hope that through this article and our videos, we managed to convey the importance of setting up the ESOP in the right way and as early as possible.
As always: we try to do this at the best of our capabilities, and we are far from perfect. If something in these rules looks wrong to you, or you have seen a better way of doing it, tell us. You can comment below this article, or message me directly on Linkedin.
Thank you for reading, and see you in two weeks with the final piece of the puzzle of the standard docs: A summary of the Investment Agreement and the By-laws.
Enjoy the rest of your summer holidays everyone!
-Ire
