An Employee Share Option Scheme can be an effective long-term incentive for employee loyalty and productivity to really turbo-charge your tech startup, but is it for you, and when is the best time to introduce it?

Share options gives an employee the right to buy a certain number of shares in your company at a fixed price at some period of time in the future. Here is how it can turbo-charge your company.

1. Your company’s employees are incredibly loyal. Even in roles where turnover is expected to be greatest, employee retention is phenomenal in part because they own equity. Some geographies are more susceptible to employee turnover than others.
2. Your company’s employees are productive. Your employees want to work hard in part because they own upside. As a result, revenue/employee is high and your business is able to reach profitability on less capital relative to peers. In some cases, short-term incentives can be more effective, such as quarterly or annual sales bonuses and commissions. The two incentives are not mutually exclusive.
3. Employees work for below market salaries. Because they love where they work and feel like they have upside, even though your company is located in a high-cost city, employees are working for below market wages. In their view, the equity ownership is part of their compensation, so they’re willing to take lower salaries. As a result, your company is able to conserve cash.
4. Employees have an incentive to stay. Employees that don’t stick around lose options. Normally a cliff and vest approach ensures this.

A 1-year cliff means that an employee must stay at your company at least 1 year from the option grant date in order for the first 25% of options granted to become theirs. If the employee leaves on day 364, they get nothing.

The 4-year monthly vest thereafter means that the employee will earn the remaining 75% from day 366 through the 4th year on a monthly basis. Each month through the 4th year (vesting period), 1/48th of that employees’ options will vest. Employees that leave before the vesting period ends forfeit any unvested share back to the option pool.

The granting of share options will have a dilutative effect on you and your existing shareholders, so one has to consider how much shareholding to allocate and when best to launch the Scheme.

The quantum depends on factors such as number of existing and projected employees, how broad-based the Scheme is (only management or for all employees) and how much you are prepared to dilute, but we typically see a range of 5-15% of total shareholding. A Scheme involves allocating the shares into a pool. The share options are then allocated to employees based on internal guidelines, such a seniority and length of service. Options that do not vest go back into the pool, and there should be capacity to allocate options to future employees.

At which stage of your company’s evolution should you introduce the Scheme? Probably not before you have a fair number of employees and a management team, as you probably need to focus on other priorities until then. If you are doing an investment round, you should discuss this with potential investors to get alignment on your Scheme plans.

The biggest issue with having a Scheme in your unlisted company is that of liquidity, and this can also affect your timing in introducing a Scheme. Once your employees acquire shares, they cannot easily sell them. This can be a problem to the extent that if employees don’t see the company growing strongly with the prospect of an IPO or a company sale in the next few years, then they might consider the share options to be close to worthless. (Typically there is a clause that provides for all employee share options to automatically vest in the event of a company sale.)

A variation on a Share Option Scheme that does not have the liquidity issue in an unlisted company is a Phantom Share Scheme, which provides cash bonuses for good employee performance. These bonuses equate to the value of a particular number of shares.

A Scheme in your listed company can be very effective, as employees can track the value of their share options and can easily trade them. It is also easy to set the price of the option, which is usually the price of the share at time of allocation the options. Of course if the options are “under water” (the option price is higher than the current share price) the incentive tends to be less effective.

There are other versions of employee ownership such as direct-purchase programs, and restricted shares.

• Direct-purchase plans let employees purchase shares of their respective companies with their personal after-tax money.
• Restricted shares gives the employees the right to receive shares as a gift or a purchased item after meeting particular restrictions, such as working for a specific period or hitting specific performance targets.

An Employee Share Option Scheme can be very effective in your growing listed company. There is certainly a case for a Scheme in your unlisted company, as long as there is a liquidity event on the not-too-distant horizon. To be a meaningful incentive, the Scheme should probably not be introduced before your company is in a strong growth phase.