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ESOP cheat sheet By @MBentivoglio

There are many great assets in the internet about the ESOP topic but most of them lack the private information or thoughts behind the structures. I'm sharing with you what others don't, the nicky picky secrets that are only told in private rooms, and belive me, I've been hundrends of hours and invested more than a $ million in advisors/lawyers fees.

Also, come back from time to time, I will be updating this material as those meetings never end.

Shares / Share Price

This is a fractional ownership of a company. It is literally what you have when you are a partner of a company. When you buy 1-share, you must pay a price for it. In public markets, the price is defined by supply/demand, but in private markets, the price can be defined in many ways.

In economies such as the US, you have rules such as the valuation defined in Section 409a, where an independent advisor set a fair market valuation for your startup. This often used for tax purposes. In Latam, rules are different, and startups can define the share price in many ways:

1. From an independent financial advisor.
2. Using the last round / fund raising process.
3. Using a proprietary formula, such as X _ ARR or Y _ Ebitda LTM.
4. Not having a price by using a symbolic number like $0.01.

Vesting

Vesting defines the timeline of your plan.

1. How long it will take to fully vest.
2. The periodicity of the vesting. For example, you can have plans ranging from 3 to 5 years to fully vest and with monthly, quarterly, yearly vesting. If the vesting period is 5 years with a yearly periodicity, it means that every year you have the right to buy X number of shares.

Then, it is also important to understand how much shares you can buy during the vesting period. Some options are equally distributed, let’s say 5 years, you will have the right to buy 20% of the total number of shares every work anniversary.

The periodicity comes with the proportion and the proportion can be defined equally or disproportionally. Some common examples are: 3 Years, 30/30/40 4 Years, 10/10/30/50 5 Years, 20/20/20/20/20 In some cases, a company can set their vesting schedule at 7, 8, 10 years. To compensate for longer vesting schedule, the number of shares issued is larger.

Cliff

A vesting “cliff” means that there is a period of no vesting, once that period ends, starts the vesting schedule. Basically, is a ‘dead’ period. Before the Cliff period ends, nothing happens. Usually, companies define a Cliff period to test if you really going to engage with the company.

Think about it, if you are the company owner and you are not sure if a new hire is going to engage culturally etc. You don’t want to grant shares right away, so you define a Cliff period. For example, in a 48-month vesting schedule with a 12-month Cliff, no vesting occurs for the first 12 months, but at the 12-month point, the stockholder receives full credit for 12 months of vesting. You can understand the Cliff as an updated version of the “experience period”.

[Pro Tip] - When you find an offer with “Our plan doesn’t have Cliff” look out for the vesting structure. A “no Cliff” plan with a yearly vesting periodicity is basically the same of having 5 Cliffs. Options / Call Option Options are financial derivatives created to execute an action based in some pre-negotiated arguments. For example,

Call option

A call option is a right to buy shares when some conditions are met. You don’t own shares until the options are executed and converted in shares. The important concept is that a call option is a right, not an obligation, and have parameters defined when the call is granted or sold. A call option is specified by a period, a price, and an exercise price.

Period = how long the option is granted Price = the price you pay to have the right Exercise price = is the price of the shares you are going to pay when you execute the option

Some ESOP comes with a call option in case an employee leaves the company. The price is already defined, and it can be whatever the hell the parties agree. That said, pay attention to the valuation formula, the exercise price, and the price per option. The company offers the employees a discount to buy their shares back when they leave the company. This is a common practice in private companies because most ESOPlans are built to benefit the employees at the company.

Maturity

Every plan must have an exercise window. Depending on the plan, employees can exercise in the same periodicity of the plan. In other cases, they only exercise when a liquidity event occurs.

Importantly, they also expire when the employee leaves the company. Any rule can be built to accommodate that, for example, some plans offer a 90-day period to exercise the options. This period can vary from 15 to 180 days.

Tail

Some ESOPlans have the Tail rule. This is a mechanism to protect the employee of having its shares repurchased at a lower price before a higher liquidity event.

Tails can be used in ESOPlans that have call options against every stock already vested by the employee. For example, let’s say an employee was granted 1,000 shares and this employee executed and paid for the shares. Those shares now belong to the employee and if the employee leaves the company, the company can buy those shares back at a defined price if a call option is in place.

In this case, the Tail gives the employee the right to receive any additional $ value from the shares sold if those shares are sold again. For example, if the employee leaves the company and the company buys those shares at $12 each. If the company goes public or is acquired by a competitor paying $15 for each share, the employee has the right to be compensated by $3 for each share.

The Tail is also granted for a period, usually ranging from 3 to 12 months.

Final notes:

There are many ways to build a ESOPlan and the rules they need to follow can vary if the company is listed or private. Additionally, other contracts can be built to simulate a ESOPlan, but are not an official ESOPlan, some examples are simple vesting contracts, phantom options, etc.

This cheat is intended to help employees, founders, and anyone that is negotiating or learning about ESOPlans. Be sure to reach out to a specialist if you need further assistance and if you want to follow my journey, I’m building my second fintech startup, I’ve bootstrapped to the largest Series A of a fintech in Latin America $50 million and the 3rd largest Series B in the world $200 million, and I’m sharing real gems here: @MBentivoglio