ESOP– “Employee Share Options Plan” or “Easy to Structure but Open to Problems”

Start-ups often use ESOPs as a non-cash rewarding tool to incentivise capable senior management and advisors for their long-term services. The company thus grants the individual the right to buy its shares at a certain price (usually at a slight/huge discount on the current market price). In the hope that a company's value will increase, say, 10 times in the next five years, the prospect of purchasing its shares at a discounted price is usually appealing.

However, as easy as it may seem, an unstructured ESOP may cause many unanticipated issues for start-ups as their business grows. To help entrepreneurs avoid these traps, we plan to share a series of articles to discuss the issues that many start-ups have encountered while implementing ESOP.

 In the coming weeks, we would be addressing the following ESOP-related topics:

1)   Valuation of a company and the pricing of its employee stock options

2)   How and when to grant stock options to employees?

3)   What are the critical terms of an ESOP?

4)   Tax implications of ESOP for the employees and how it will affect potential listing of the company.

We aim to help new entrepreneurs grow their business and avoid unnecessary costs by being more cautious in devising ESOP. Please follow our weekly articles if you are interested in ESOPs; we hope they will provide you helpful insights for your business.

Valuation of a company and the pricing of its stock options

Most of our clients use ESOP as a part of the remuneration offered to their management team to save money. Our past consulting experience suggests that CEOs often encounter a lot of questions while calculating the number of options they should grant to their senior employees. The valuation of these share options is also an important topic of discussion.

For example, let us consider the following case study:

Company A’s Founder CEO wants to hire his next-in-charge – a COO who, in his current position in a big corporation, is earning an annual salary of RMB1 million. Like most start-ups, Company A would like to save some cash to develop its software products and for marketing activities. The CEO cannot afford to pay the COO the entire RMB1 million in cash, given Company A’s stage of growth. Therefore, the CEO picks an arbitrary figure and decides to pay him 40% in cash and 60% in share options.

Now, prima facie, calculating 60% of the annual remuneration as ESOP would appear to be easy. All you need to do is issue share options worth RMB 600,000 to the COO.

Here is the simple calculation:

Let us assume that the current valuation of Company A is RMB 80 million, and the total number of its shares is 10 million:

Therefore, the price per share would be:

RMB 80 million divided by 10 million shares = RMB 8 per share

If the exercise price per option is only RMB 0.001 (that is – the option holder can practically get the share for free), then the number of options to be granted to the COO would be:

RMB 600,000 / RMB 8 = 75,000 share options

After three years, Company A’s valuation increases 5 times, from RMB 80m to RMB 400m. The COO could now exercise his 75,000 share options and his resulting shares would be worth 5 times more –RMB 3 million.

By exercising all his share options, the total value he gets would be:

75,000 shares x RMB 40= RMB 3,000,000

However, the issue is more complicated than it appears prima facie. So, to start with, the management of Company A must determine its value accurately before calculating the number of share options to be granted to the COO, for the valuation of Company A would increase as its business grows, with some of the major assumptions becoming a reality.

As mentioned earlier, the valuation of Company A is assumed to be RMB 80m. In practice, its valuation is subject to some valuation methods that usually relate to the expected future cash flows of the company. As the future is difficult to predict, the CEO would have a hard time coming up with the valuation. He would neither want to underestimate his company’s valuation nor over-compensate his employees by issuing them options either at too much of a discount or too many of the units.

Let us continue to consider the following two scenarios in which Company A would want to issue share options worth RMB 600,000 to the future COO:

Scenario 1 (with Company A’s estimated current valuation being RMB 100m)

Market Price per share = RMB100m / 10m shares = RMB 10

If the exercise price is RMB 8 (at a discount), then the number of options to be granted would be:

RMB 600,000 / Value of the options (roughly estimated to be the discounted amount or RMB 10 – RMB 8 = RMB 2 per unit) = 300,000 units of share options

Scenario 2 (with Company A’s estimated current valuation being RMB 300m)

Price per share = RMB 300m / 10m shares = RMB 30

If the exercise price is RMB 8 (at a discount), then the number of options to be granted would be:

RMB 600,000 / Value of the options (roughly estimated to be the discounted amount or RMB 30 – RMB 8 = RMB 22 per unit) = 27,273 units of share options

BUT what if Company A has underestimated its valuation at RMB100m and granted ESOPs with an option Value of RMB 10?

In such a case, Company A may need to pay significantly more than it should to attract this new COO.

Well, ESOP is a good tool for retaining employees, but it also requires a lot of efforts to design a good one.

From the employee’s viewpoint, as we may see from the above few examples, it is difficult to comprehend the complicated formula to determine the valuation of the company and of the share options.

Other important issues that will be addressed in this series include:

1)   Valuation of a company and the pricing of its employee stock options

2)   How and when to grant stock options to employees?

3)   What are the critical terms of an ESOP?

4)   Tax implications of ESOP for the employees and how they may affect potential listing of the company.

CanCan Group has a proprietary data management software called CanCan, specially designed for growth-oriented companies. We are professional business advisors working on innovative ideas for the digitisation of work processes for global SMEs. We provide one-stop digitised SaaS solutions to our clients. Our team has extensive experience in providing acting CFO services to businesses that are expanding. Please contact us if you have any ESOP-related queries or any other questions.