More often than not, especially in the early stages of your startup, you don’t have enough money to compensate the people that are helping your company grow. And even if you do have some early funds, you probably need to spend it on banal things such as marketing, software development, office space, or that growing stack of bills, otherwise there will be no company at all.
While you do need to spend your money on those things that actually make your startup a company, you also need to remember that a fairly compensated team will be a happy and motivated team; and that with a happy and motivated team you have a much higher likelihood of success.
So, and therein lies the rub: how do you maintain a happy and motivated team if you don’t have the money to pay them, or at least not enough to pay them as much as they could earn elsewhere? Allow me to introduce you to STOCK OPTION PLAN (SOP).
Let’s Go Step-by-Step. What is an SOP?
An SOP is a private contract between the company and the employee that gives such employee the right to buy a number of shares of the company in the future at a fixed price set at the moment of the agreement. SOPs can be given to any employee under any rules the company chooses to create, with limited regulations depending on your country of incorporation.
SOPs come from the idea of a publicly owned company that is able to own some percentage of its own shares and allocate those towards rewarding employers. Privately owned companies cannot own their own shares, but with due notice to all present and future shareholders of a possible future dilution, they can dedicate a small percentage of shares to SOPs in order to reward employers.
How Does an SOP Work?
An SOP is granted for a pre-determined period of time. It’s based on milestones that the employee must achieve in order to earn the options over shares to buy. The usual length for a SOP is 3-5 years (vesting period), and it’s also pretty standard that the first year has no milestones at all (1 year cliff). So a standard SOP would be 4 years long, with a “one year” milestone after which the employee can execute the SOP. The longer the employee remains at the company, the more milestones he will hit, and the more options over shares he will have the right to buy at the original agreed price. Milestones can be set monthly, quarterly, yearly or in however period the company feels appropriate.
Let’s imagine it with an example: a single share of your company in 2014 is worth €1,50. Your early employee signs a contract that establishes his SOP for 4 years with monthly cliffs beginning in the second year. After the four years, when he is able to fully execute those options and buy his shares, they are worth €5 each. He will still have to “buy” them at €1,50, but he will receive €3,50 in profit for each share if he chooses to sell them at that moment.
Who Can Receive Shares?
Any employee of the company can sign an SOP. But it is true that SOPs have been used a lot to award advisors, collaborators, and mentors, on their help to make the company successful. Therefore, SOPs, being private contracts as they are, can be signed with basically anyone working or collaborating in some way with your company.
What do we have to keep in mind? In Spain, your startup will probably be in the form of an SL. Going back to where I explained privately-owned companies, ALWAYS remember to tell your shareholders that they will be diluted if the people rewarded SOPs execute them in the future. In your Shareholder Agreement, you should include a clause informing the shareholders of this possibility in order to set realistic expectations.
Wrapping up, SOPs are based on the premise of the company doing well. Your employees need to know that the salary they are giving away for options on stock will only be effective if the company performs well and reaches a significant liquidity milestone (ie: acquisition or IPO). If the company goes bankrupt, the shares are worth €0 and there will be no economic gains for shareholders.
From the employee side, SOPs are a big leap of faith (or a gamble) on an early-stage venture. You need to reward your early employees with SOPs knowing that if they work hard and the company does well they will benefit directly, thereby incentivizing them to go the extra mile in the early days of your startup. However, the flipside is also true and if the company is in bad shape and they know that the SOPs won’t be executable, it might provoke the wrong effect into not caring for the company anymore.
Take that leap employers and employees, take it.
(Part 2: Phantom Stock Option Plans coming soon)
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