Employee Share Options Schemes are often used by start-ups to enhance the motivation of employees and align their interests with that of the company, in particular in situations where start-ups may not be able to match the market salaries of the employees competitively.
After all, it’s the dedication and perseverance of your team that will ultimately help transform your start-up into a viable and profitable business. Like most successful entrepreneurs, your requirements for motivating employees would encompass improving productivity while maintaining low costs. This article will discuss several methods and illustrate how employee share options schemes are becoming an increasingly popular method to motivate employees in start-ups.
What are Employee Share Options Schemes?
Employee share options scheme is a type of contract given by the employer which allows the employee to purchase a certain number of shares of the company’s stock, at a fixed price, over a specific time period.
The two common types of schemes are: Incentive Stock Options (ISO) and Non-Qualified Stock Options (NSO).
1. What is an Incentive Stock Options (ISO) scheme?
Incentive stock options (ISO) are rights to buy stocks of the company at a discount, usually provided as a company benefit to employees. ISOs are issued on the grant date, which gives employees the right to exercise their options on the exercise date. Once the option is executed, the employee can choose to sell the stock immediately or wait for a period of time before selling.
ISOs usually contain a vesting schedule that employees must meet to exercise options. ISOs can usually be executed at a price lower than the current market price, thereby allowing employees to directly profit from the sale of shares.
2. What is a Non-Qualified Stock Options (NSO) scheme?
NSOs are similar to ISOs but the stock options that do not meet the conditions for employees to enjoy preferential tax treatment.
3. What is the difference between incentive stock options and non-qualified stock options?
The main difference between these two is that ISOs are given preferential tax treatment and are offered to a less wide range of people. Issue of ISOs by the company entitles it to claim tax deductions on profits. From the employees' perspective, the profits of ISOs are taxed at the capital gains rate, not at the higher tax rate on ordinary income. Whereas, employees exercising NSOs are required to pay tax at the time of the exercise of options (purchase of stocks) and the sale of stocks.
For larger companies, ISOs are usually only offered to executives and/or key employees of a company. NSOs are also typically targeting management and senior employees, as opposed to qualified plans, which must be offered to all employees.
For start-ups, ISO’s are the most common scheme to choose given the limited company size. Moreover, employee share options can only be exercised during the period in which the employee is working for the company.
Share Options terms you should know:
- Vesting Schedule: This is the period in which you are allowed to purchase the company shares and take full control of the options contract. If an employee chooses to exercise his option before or after the vesting period, then they will be required to purchase the stocks at the current market price.
- Exercise Price: This is the specific price that employees are allowed to purchase the share during the vesting period. It is listed clearly in the contract and the employee would be required to pay this price regardless of whether the current market price is higher or lower.
- Grant Expiration Date: This is the date in which the contract expires. After this date, the employer is not required to honour the share options agreement.
Benefits of Employee Share Options for Employers
- An incentive to work harder: In your start-up, giving employees share options will motivate them to work harder and achieve positive outcomes. Rather than tirelessly coming to work every morning for their paycheck, they will instead be refreshed and intrinsically motivated to work for your firm. A small piece of ownership will ensure they are working towards a goal and for the growth and benefit of the company. Share options will also help your employees feel more connected to your ideas and the company, ultimately improving productivity.
- Cost-effective Compensation Package: By offering share options, the employment package becomes more attractive to employees and gives you greater room to negotiate on other areas of the employment contract. Most start-ups also have limited funds and may be unable to pay employees immediately. Hence, by offering share options, you will be able to limit your costs and shift them to the future while motivating your employees simultaneously.
- Lower Employee Turnover: By choosing a vesting period that only begins several months or years after the share contract was granted, you can reduce the risk of employees leaving your start-up. You will gain long-term guarantee for staff retention as vesting share options typically requires employees to stay in the company for a period of time.
How much Equity Share should start-ups give to their Employees?
The amount of equity share that you should give your employees would depend on a range of factors but typically ranges from 5-15%. If you are the sole owner of the company, then you should be willing to give a higher percentage of equity.
If there are two or more owners, you may consider giving a percentage share on the lower end of the spectrum as you would want to maximise your individual shares. Moreover, since the majority of start-ups tend to kick off after a few years, it is typical to offer a vesting period of around 1-2 years so that you can ensure employees stick with you.
What you may consider before granting Employee Share Options?
- Dilution of Shares: Dilution could be very difficult in the future as equity may not want to be distributed among more shareholders. If you want to provide shares for your family or friends, you may be restricted as you have already given some to your initial employees.
- Difficult to Value Shares: Share options are difficult to predict and value in the future. There is a lot of uncertainty in how your start-up will perform and therefore it is difficult to predict the value of the share. If the market price of the stock is cheaper than the exercise price, then this would be an advantage for you as an employer. However, if the market price of the stock is higher than you would expect employees to exercise their options which may be unfavourable for you as they pay less for the stock.
- Collective Effort: Growing a start-up and increasing its market value is a group effort and so an employee has to rely on other individual employees as well. A slack off or free ride from one employee can result in the whole start-up failing. Employees will be aware of this and may see no incentive towards working hard since they might not trust other employees to put any effort and thus won’t see the worth in doing so either.
Other Methods to Motivate Employees in a Start-Up
- Non-monetary bonuses: Bonuses are typically offered in larger scale companies and are often given in the form of cash. However, as a start-up, you may not be able to provide cash or liquefy quickly. Hence, employers may consider providing bonuses in non-monetary forms for things that the individual employee may enjoy. For instance, if one of your employees enjoys music, then you could purchase tickets to the next concert for them. Providing tailored bonuses for things that your employees intrinsically value could demonstrate that you care about their interests and that they are valued in your company, thus ultimately improving productivity.
- Happy Hours: Weekly, bi-weekly, or even monthly dinners and drinks with the entire team can have a significant and meaningful impact on improving motivation for your employees. This is a relatively cheap out-of-pocket expense that can help build out of work relationships and connections.
- Create Intrapreneurs: An effective method to motivate employees in a start-up is to help them envision themselves as intrapreneurs. This includes lower hierarchical structures and giving employees the freedom to choose their own projects. This will help ensure that they are motivated since they are working on their interests and view it as their own individual projects. It’s important to note that this level of freedom should only be given to employees as long as it still benefits the company.
Documents you need to Grant Employee Share Options
Employee share options is definitely a viable method to help motivate employees and help start-ups grow. It is extremely useful to boost productivity and is remarkably cost-effective. As an entrepreneur and employer, there are many steps to consider when creating the contract and should be optimised depending on the type of company.
We understand this may be difficult for you, which is why we compiled a free contract document for you to use. What’s more is that this contract is specially made in favour of you, the employer.
For an employment agreement between the company and a junior employee, please click on the following link: https://docpro.com/doc282/employment-agreement-junior-employee-with-share-options-company
For an employment agreement between the company and a senior employee, please click on the following link: https://docpro.com/doc276/employment-agreement-senior-employee-with-share-options-company
Please note that this is just a general summary of the position under common law and does not constitute legal advice. As the laws of each jurisdiction may be different, you may want to speak to your lawyer.