Employee Stock Ownership Plans (ESOPs) have become a popular way for companies to reward, retain, and motivate their staff. In 2021, the Nigerian Exchange Group (NGX) introduced equity-based incentives, including an ESOP, as part of its employees' remuneration.
By offering a stake in the business, ESOPs align employee and company interests, fostering loyalty and incentivizing performance. However, creating an ESOP pool requires careful planning, legal knowledge, and strategic thinking.
In this guide, we’ll walk you through the entire process of setting up an ESOP pool. We’ll cover everything from understanding its purpose and benefits to the key steps, allocation formulas, and legal compliance.
This guide is your go-to resource for navigating ESOPs — whether you’re a startup founder, HR professional, or financial advisor.
TL;DR: Key takeaways
- An ESOP Pool is a portion of company equity set aside for employees as part of their compensation.
- An ESOP aims to attract talent, retain employees, and motivate performance by offering equity ownership.
- When creating an ESOP pool, define the equity percentage, assess dilution, complete legal documentation, and manage allocations.
- To ensure legal compliance, the ESOP must comply with tax regulations and involve a plan administrator for oversight.
- Communicate the ESOP plan clearly to prevent ambiguity. Avoid under-allocating equity, and stay transparent about its benefits.
What is an ESOP pool?
An ESOP pool is a set percentage of a company’s equity reserved for employees. These shares are distributed over time through options, allowing employees to acquire ownership after meeting specific conditions like tenure or performance.
Purpose of an ESOP pool
An ESOP is designed to achieve two objectives:
- Primarily to attract and retain talent, particularly for startups where offering equity can supplement limited cash compensation.
- It also helps align employees’ goals with the company’s success, fostering a sense of ownership and shared growth.
Key benefits of creating an ESOP pool
Attracts top talent
Startups use ESOPs to attract skilled professionals in Nigeria’s competitive job market.
Here’s how:
Written by Omoruyi Edoigiawerie, a seasoned startup attorney with over a decade of experience. Learn more.
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In the early stages, startups require top talent to succeed. However, given their limited capital and the competitive job market, they often can’t adequately compensate those talents. Setting up an ESOP as a potential incentive will allow startups to incur minimal expenditure on employee compensation while creating a sense of ownership.
For example, suppose an employee is offered an annual compensation package of ₦20,000,000. With an ESOP in place, they’ll only be paid ₦14,000,000 in cash, and the remaining ₦6,000,000 will be offered in stock options when the company's value increases.
Retain employees
This is an extension of the previous point. Employees are more likely to stay with a company if they stand to gain equity.
An ESOP motivates employees to stay dedicated, especially when the company cannot afford to pay market-rate salaries yet. Allowing employees to own part of the company’s shares imbues them with a sense of ownership, encouraging them to do everything they can to help the company succeed.
Boosts investor confidence
An ESOP is also a way for startups to attract investors. Since an ESOP pool attracts the best talent who will be invested in the company’s growth and success, investors are confident that the company is in safe hands, so they’ll back it.
Key considerations when creating an ESOP pool
Creating an ESOP can be complicated because of the many factors you must consider meticulously.
Here are six factors for startups to consider when creating and implementing ESOPs:
Cost of setting up the ESOP
First, the initial cost of setting up an ESOP is quite high. This includes fees for legal consultation, valuation of the company's stock, and administrative setup costs to ensure compliance with regulatory standards.
Additionally, companies may need to invest in ongoing maintenance, such as hiring third-party administrators and conducting annual stock valuations to manage the plan effectively.
Determining the ESOP pool size
The size of an ESOP pool depends on factors like:
- Stage of the business: Startups often allocate a higher percentage to attract top talent, while established companies typically reserve smaller pools.
- Future hiring plans: Anticipate the number of future hires and ensure the pool can cover their equity offers without frequent adjustments.
- Equity allocation per employee: Establish limits on how much equity can be offered to individual employees, maintaining balance and fairness in distributions.
- Investor preferences: Align with investor expectations to avoid conflicts over equity dilution.
ESOP allocation formula
Several factors determine allocation to ensure fairness and alignment with business goals.
- Market benchmarks: Companies often reference industry standards or competitor practices to determine fair allocation percentages for specific roles.
- Seniority: Key executives or leadership positions typically receive larger allocations than other employees in the company due to their decision-making responsibilities.
- Strategic roles: Critical hires or specialized roles essential for scaling the business may warrant higher allocations to attract and retain such talent.
- Performance metrics: High-performing employees may earn additional shares as rewards for exceeding targets, achieving milestones, or delivering exceptional results.
- Time-based vesting: Shares are distributed over a set vesting period (e.g., 4 years with a 1-year cliff), encouraging long-term retention and loyalty.
- Existing equity pool size: The total percentage of equity available in the ESOP pool impacts individual allocations, ensuring a balance between incentivizing employees and maintaining shareholder interests.
Impact on ownership and dilution
Since ESOP means ownership distributed among employees, it can dilute the ownership of existing shareholders. The founders should use an ESOP dilution calculator to estimate how the pool will impact equity stakes, ensuring alignment with investor expectations.
The ESOP agreement should unambiguously state what happens when an employee with vested options leaves the company.
Financial stability
Companies with ESOPs should have strong profitability and steady, ideally growing, cash flow to sustain the costs of contributions and payouts under the plan. Early-stage startups and small businesses often lack the financial resources to support such plans effectively.
Employee continuity
A successful ESOP relies on employee continuity and strong leadership. Consistent employee retention ensures the plan remains viable, while a capable management team provides the stability needed for long-term success. An ESOP may not align well with a company’s structure without these elements.
Planning ESOP pool according to the growth stages
Effectively structuring an ESOP pool requires adapting strategies to the company’s growth stage.
Here’s how founders can optimize their approach across different phases:
Early stage (seed round)
Challenges: Limited liquidity and resources constrain the ability to offer competitive cash salaries.
Strategy:
- Use ESOPs as a primary incentive since cash components are minimal.
- Offer generous ESOP grants to attract top talent critical for growth.
- Maintain flexible policies to align with the needs of employees and business demands.
Objective: Prioritise attracting and retaining key employees willing to bet on the startup’s future success.
Growth stage (Series A and B)
Challenges: Startups raising Series A or B rounds begin generating cash flow but face higher employee expectations.
Strategy:
- Increase cash components to meet market expectations, reducing reliance on ESOPs.
- Reserve ESOPs for high-impact employees and use them strategically to reward exceptional performers.
- Offer ESOPs to new hires selectively, especially when addressing business-critical needs, such as filling strategic roles.
Objective: Balance cash and equity incentives while minimizing dilution and addressing retention challenges.
Maturity stage (Series C and beyond)
Challenges: High company valuation increases the fair market value (FMV) of stock options, reducing the perceived value of equity grants.
Strategy:
- Shift toward performance-based ESOP grants, rewarding sustained contributions and achievements.
- Reserve ESOPs for strategic hires or as retention tools for critical employees.
- Leverage a balanced mix of cash and equity to align rewards with market and employee expectations.
Objective: Maximise employee satisfaction and align incentives with the company’s mature operations and high valuation.
How to create an ESOP pool
Establishing an ESOP pool involves careful planning and alignment with legal, financial, and strategic goals. Here’s a step-by-step guide to get you started:
Step-by-step guide to creating an ESOP pool
Step 1: Define the pool size
- Determine allocation percentage: For startups, the pool is typically 10-15% of total shares.
- Anticipate growth: Consider future hiring needs and investor expectations when deciding the pool size.
Step 2: Obtain a valuation certificate
- Set the strike price: This price is based on a valuation report, often from the last six months.
- Use a shared report: You can use the same valuation report for ESOP and investor-related activities during fundraising.
- Account for recent changes: Update the valuation if there has been a new funding round or liquidation event.
Step 3: Develop the ESOP scheme
- Engage legal advisors: Draft a formal document outlining eligibility, vesting periods, and allocation terms.
- Discuss terms: Include specifics like the vesting schedule, cliff period, and conditions for granting options.
- Set employee-friendly terms: Ensure the ESOP scheme is attractive to employees and offers clear benefits to enhance retention and recruitment. Otherwise, the effort will be fruitless.
Step 4: Get board and shareholder approval
- Formalize the ESOP: After drafting the plan, present the scheme to your board and shareholders for approval.
- Act early: Avoid delaying the ESOP creation until funding rounds, as it may lead to pricing conflicts and friction with investors. You won’t be able to give ESOP to early employees at the price you promised them.
- Ensure legal validity: ESOPs must be officially approved to carry legal weight; informal grants are not enforceable.
Step 5: Award ESOP grant
Once you’ve completed all the steps above, you can proceed to:
- Distribute grant letters: Provide employees with formal letters specifying their allocation details.
- Manage allocations: Assign options based on seniority, roles, and performance.
- Track and review: Regularly monitor the plan’s effectiveness and adjust as needed.
Who manages the ESOP pool?
The ESOP plan administrator oversees the management and investment of ESOP funds. Depending on the plan's complexity, the company or a third-party administrator may fill this role internally.
Legal and compliance aspects of ESOP pools
ESOP plan compliance
Companies must adhere to tax laws and equity plan regulations to ensure compliance.
Key steps include:
- Consulting legal and tax advisors.
- Registering the ESOP with relevant government agencies.
- Assigning an ESOP plan administrator for oversight.
Is an ESOP a defined contribution plan or a profit-sharing plan?
An ESOP is not a defined contribution plan like a pension. Instead, it’s a profit-sharing plan where employees receive shares of company stock, aligning their rewards with company performance.
Is ESOP taxable?
The taxability of ESOPs depends on the jurisdiction, type of option granted, and specific tax laws.
Here's how ESOP taxation is addressed in Nigeria:
Taxation under Nigerian law
- The Personal Income Tax Act (PITA) requires that all salaries, wages, allowances, and other employment benefits be subject to personal income tax.
- Although stock options are not explicitly mentioned in the Act, they are taxable under "gains from employment."
- In 2017, the Lagos State Internal Revenue Service (LIRS) clarified the taxation of employee shares and stock options (including ESOP):
- If an employee acquires stock at zero or below fair market value, the difference between the acquisition cost and market value is taxed as income.
- Dividends earned during the vesting period are also subject to personal income tax.
Types of stock options
- Incentive stock options (ISOs): ISOs are a form of equity compensation that gives employees the right to buy company shares at a discounted price.
- ISOs may qualify for special tax treatment. To benefit, shares must be held for at least one year after exercise and two years from the grant date.
- Gains are taxed as capital gains, not earned income.
- Typically, no tax is due at the time of exercise.
- Non-qualified stock options (NSOs) don’t receive favorable tax treatment, unlike Incentive Stock Options (ISOs). Taxes are due when options are exercised, and shares are sold, often leading to higher overall tax liability than ISOs.
Uncertainties in taxation
Beyond Lagos State, the treatment of ESOPs across other Nigerian states is unclear, as uniform guidance on taxation is lacking.
Key recommendations
To understand tax implications and ensure compliance, employees and companies should:
- Consult with tax professionals who specialize in Nigerian tax laws.
- Stay updated on regional directives, especially in states outside Lagos.
Best practices for creating and managing an ESOP pool
Best practices for creating an ESOP pool
- Set clear objectives: Define why you’re offering an ESOP and how it aligns with company goals, such as attracting top talent, rewarding performance, or fostering long-term retention.
- Stay transparent: Communicate the ESOP's benefits, value, and terms regularly to employees. Include updates about company performance and how it impacts their equity.
- Growth plan: Design the ESOP with future expansion in mind. Allocate a sufficient share pool to accommodate new hires and scale without excessive dilution.
- Engage in individual discussions: Arrange one-on-one meetings with employees to ensure alignment of goals and clarify their potential financial benefits. Be open to feedback and realistic about projected gains.
- Customise for your company: Build the ESOP from scratch to suit the company’s unique needs, balancing flexibility, realism, and employee-friendliness. Align the policy with the company’s financial health, growth objectives, and industry standards.
- Legal compliance: Ensure the ESOP policy adheres to the legal and tax regulations of the company’s jurisdiction. Confirm whether ESOPs are taxable, and consult with a qualified attorney to draft the agreement.
- Offer units, not values: To maintain fairness, structure ESOPs in terms of units (e.g., stock options or shares) rather than monetary value. For example, offering ₦12,000,000 worth of options today may result in disparities post-fundraising due to valuation changes, whereas allocating a fixed number of units (e.g., 50,000 units) ensures consistency.
- Review and adjust the plan: Routinely evaluate the ESOP structure to ensure it remains relevant and beneficial to the company and employees as the business evolves.
Common mistakes to avoid when creating an ESOP pool
- Under-allocating equity: A too small pool may fail to attract or retain top talent.
- Over-allocating equity: An overly generous ESOP can dilute the founders’ and investors’ shares, potentially impacting their long-term interests.
- Not planning for future growth: Companies may fail to reserve enough shares for future hires, leading to frequent pool expansions and increased dilution.
- Neglecting legal and tax advice: Skipping consultation with legal and tax professionals can result in compliance issues, such as incorrect tax treatment or unenforceable terms in the ESOP agreement.
- Poor communication: Employees need to understand their ESOP's value, vesting schedule, and financial implications. Lack of transparency can lead to dissatisfaction and mistrust.
- Failing to align with company goals: ESOPs should reflect business objectives, such as rewarding performance, retaining critical employees, or incentivizing innovation.
- Ignoring performance metrics: Allocating shares without tying them to performance or contribution can demotivate top performers and create inequity.
- Issuing ESOPs without board approval: Granting ESOPs informally without proper legal documentation and board approval can result in disputes and a lack of enforceability.
- Delaying ESOP Creation: Waiting too long to set up an ESOP can lead to valuation challenges. Employees may lose out on potential benefits, particularly if the strike price rises significantly post-fundraising.
- Setting unrealistic terms: Vesting schedules or strike prices that are too restrictive or impractical may reduce the ESOP's perceived value.
- Overlooking exit strategy considerations
Failing to explain how ESOPs will be handled during company exit events, such as an acquisition or IPO, can create uncertainty for employees.
- Failing to periodically review the plan: ESOP policies must evolve with the company. Regular reviews ensure alignment with market trends, business goals, and employee expectations.
Download PDF template for ESOP Policy Document
ESOP pool FAQs
What is the purpose of an ESOP pool?
An ESOP pool aims to attract, retain, and reward employees by aligning their financial interests with the company’s success.
How much equity should be in an ESOP pool?
There is no particular benchmark upon which startups should build their ESOP pool. The allocation can depend on factors like the market position and investment stage. Early-stage startups typically set aside an ESOP pool of 10% to 15%, with adjustments based on growth and hiring plans.
What happens when an employee leaves a company before all shares are vested?
When an employee exits before full vesting, they forfeit all unvested shares. The employee, however, retains vested shares, provided the vesting cliff has been met. If an employee resigns before the end of the cliff period (e.g., the first year), they forfeit all their stock options, vested or unvested.
Should you set up an ESOP pool before venture capital (VC) invests?
It’s often recommended to wait until after initial VC discussions to finalize the ESOP pool:
- Pre-fundraising: Avoid creating a full ESOP pool as it dilutes founders’ stakes unnecessarily.
- Post-fundraising: Collaborate with VCs to establish the pool, sharing the dilution impact between founders and investors.
This approach effectively balances equity distribution between stakeholders.
Is an ESOP pool a good way to attract talent?
ESOP pools are particularly effective for startups with limited cash compensation, offering employees long-term rewards instead.
What happens to ESOPs when a company is sold or IPOs?
During an acquisition or IPO, ESOP holders can do two things:
- Sell shares: Liquidate shares at the current valuation.
- Convert to public stock: Retain the equity stake in the public entity.
Where do you include the ESOP?
ESOP details should be included in founder agreements to outline the pool's allocation and terms and employment agreements to specify stock options granted, exercise price, grant date, and vesting schedule. These documents ensure the clarity and legal validity of the ESOP terms.
Conclusion
Summary of key steps in creating an ESOP pool
Creating an ESOP pool is a powerful strategy for startups and businesses to attract and retain talent while fostering a sense of ownership among employees. By carefully designing the pool, addressing legal requirements, and communicating its value, companies can ensure the long-term success of their equity plans.
Final thoughts on ESOPs for startups
For founders and HR professionals, understanding the mechanics and benefits of ESOPs is essential for founders and HR professionals. With the right approach, these plans can drive performance, loyalty, and shared growth for all stakeholders.
