Who is ESOP and what does it want from us

I will not be referring here to (A)esop the Greek author of fables, but to ESOP – Employee Share Option Plan.

The starting point is that we want the important people in the company to have their personal goals very well aligned to those of the company. And so we try to build a system in which these people are rewarded accordingly. We’ll deal today only with the business elements of this issue and I will try to convince a lawyer to tell us in a later post about all the legal elements involved and how it all applies in Romania.

Therefore, the reward for these people must (may) come in three shapes:

• Fixed salary – It’s what pays the bills. It must be enough to ensure you a decent life style and, in order to take your salary, you must do what is required of you;
• Bonus – It represents the difference between a decent life and a beautiful life. The percentage between salary and bonus is up for discussion – for instance, the more technical the employee, the lower the bonus percentage is (up to 10/90) and the more the employee sells, the higher the bonus percentage goes (up to 50/50). The bonus is for what we call “the extra mile”. It rewards proactive attitude, special achievements, innovation etc.
• Equity – Here lays the difference. Those who receive a form of equity have the opportunity to make a fortune. You may receive nothing at the end of the day, but then again you may also have worked hard for a lot of money. In fact, it’s the “supreme” method of aligning the interests of the shareholders with those of the employees, employees who in turn become shareholders.

The essential principle with ESOP is that all those who receive such Options must benefit only from that company’s growth to which they directly contributed. Practically, they’ll buy company Shares at the market price valid on the day they were hired (or on the day they received that Option) and they’ll sell those shares at the price at which the company is afterwards sold/listed, benefitting from the growth to which they contributed. Things become a little bit more complicated because: a) the company doesn’t want to give you Shares on day 1 and then for you to leave – therefore, “the vesting period” was invented, which means you are allowed to buy those shares gradually, year after year, earning the right to all the shares if you work for the company for 3-5-8 years; and because b) you usually don’t have the money to buy the shares (exercise the option). What happens in fact is that, when the company is sold, you buy and sell the shares at the same time, which means you only receive the remainder – which was actually the main goal.

Let’s do a little math in order to understand things better:

Year 1: We have a company with 100,000 shares, in a line in which companies are usually valued 1xRevenue (which means the company’s value equals its revenue per year, multiplied by a multiple of 1). This company had revenue last year of three million Euros and wants to hire John as Sales Manager, offering him (as I was saying earlier) a net salary of 2,000 Euros per month, a bonus (depending on reaching his sales targets) of another 2-3,000 Euros and some equity.

The value of this company is therefore 1 x 3 million Euros = 3 million Euros;
The value of a share is 3,000,000 / 100,000 = 30 Euros;

Let’s say John receives 500 Options (the Option to buy 500 Shares), obtainable within a vesting period of 5 years, which means 100 shares per year, at the market price valid today (30 Euros per share). This means that in a year he’ll be able to buy 100 shares at 30 Euros per share. And likewise every year, so after 5 years he’ll be a shareholder in that company, owning 500 shares for which he paid 30×500=15,000 Euros.
But we have two problems: 1) John doesn’t have 15,000 Euros and 2) he doesn’t want to take the risk – the company may do well, or perhaps it doesn’t. Why (potentially) throw those 15,000 Euros? Therefore, he doesn’t buy the shares the moment they become available, what he does is he waits to be sure of his gain.

Year 2: In order to grow, the company wants to bring in more investment – with more money they’ll be able to grow more. So they negotiate with an investor to bring 2 million Euros in the company, based on a “pre-money valuation” (which is the company’s worth before investment) of 5 million Euros. This means that: the Company performed better in year 2 than in year 1 because the company’s revenue grew from 3 million to 5 million and the company’s value grew accordingly. Before the investment, the value of a company share was 5,000,000 / 100,000 = 50 Euros. So, potentially (because there has been no exit yet), John gained 20 Euros per share, which means 10,000 Euros for those 500 shares.
The arithmetic of the investment itself is that the Investor brings the 2 million in addition to the existing 5 million as company value. The new value of this company is now 7 million (the initial value of 5 million + 2 million in cash in the bank). For the 2 million Euros, the investor receives 40,000 newly created shares (proportional to the values). So now the company will have 140,000 shares and it’ll be worth 7 million Euros, each share being worth still 50 Euros.
John will now own a smaller percentage of the company (0.36% as opposed to the initial 0.5%), but in fact the value of his shares is exactly the same (50 Euros per share). What is more, the chance that the value of his shares increases is even bigger now – all that is need is for all those interested in the company to perform well (which is why John received the shares in the first place, right?).

Year 3: Everyone works; the investment hasn’t created the added value (noticeable in the company’s revenues) that can make the difference.

Year 4: The company’s revenues are now 12 million Euros. So the company’s value is 12,000,000 Euros and the value of a share is 85.7 Euros. An interested buyer appears and the company is sold for this price.

What happens to John: First of all, he acquires the accelerated right to purchase all the shares (we are still in year 4, so, theoretically, he is entitled to only 400 shares) – “accelerated vesting”. This happens because everyone’s goal is to sell the company as profitable as possible. Then he buys at 30 Euros per share (strike price) the 500 shares promised. 15,000 Euros – on credit :-). Then he sells the shares at 85.7 Euros per share. He gets 42,857 Euros from which he pays the 15,000 Euros debt and he is left with his very own 27,857 Euros.

Comments:

• This exercise is only meant for you to understand the math behind the issue. It’s certainly not a suggestion regarding the size of the figures. Think about the fact that Facebook grew millions of times over and that those who had options with Facebook at a price of 1 dollar per share sold them for millions of dollars, becoming very rich in the process. Likewise, many people had options at companies that died and so they got nothing out of it.
• Options are not an instrument that can bring you 100 Euros more to your salary. This can be done by negotiating the salary and the bonus. Options are an instrument meant to make you think as a shareholder and see the company as a whole. It is meant to make you do everything in order for the company to grow and for you to become rich from your own work.
• It’s not important how much you own in terms of percentage from that company, but how many shares you own and the value of a share.
• Why does John have to buy the shares, why doesn’t he just receive them for free? – because it’s fair for him to gain only from the value he built in the company. It’s not fair for him to benefit from the value built by those before him.

Important terms:

• Exercise price – the price at which you sell the shares. It’s the market price in Year 4 in our example – 85.7 Euros;
• Strike price – the price at which you buy the shares. Usually, it’s the market price on the day the shares were granted;
• Vesting period – the period after which you are allowed to buy all the shares. There are various patterns of obtaining shares (linear, cliff etc…), as well as various alternatives in terms of acquisition conditions (to continue being an employee etc.);
• Expiration – Assuming an exit in a timely manner is not achieved, you have a term (usually 10 years) to buy the shares. If you want to do that, you become a standard shareholder in that company;
• Non-transferable, Drag-along, Non-voting – terms that show different restrictions that come with ESOP shares. Most of the times, they are not transferable (except in extreme cases), you may be forced to sell at the same price as the majority shareholder, if he decides to sell his shares, and you cannot vote. In other words, you have access only to the material gain.

And one last comment: ESOP in this form works for companies with an aggressive growth and an exit target. Companies which are stagnant in terms of growth or even “cash-cows” or those which are built to be left as an inheritance to one’s children/to future generations cannot successfully apply this model.

I hope it helps… any comments are welcomed.

(English version by Teodora Popescu)