ESOPs can be confusing, but Kiwi Startups need them

Introduction

When I first moved to New Zealand from Silicon Valley, I was surprised to find how many different ways there were to structure an Employee Stock Ownership Plan, or ESOP. I always considered them a super critical part of my renumeration package at a start-up, so I expected more consensus.

Whenever I went to a startup related event or meeting, people repeatedly kept asking me and each other, “How should I structure my ESOP?” When I personally joined a New Zealand company, Melodics, the matter became urgent for me.?

Fundamentally, ESOPs offer employees the option to buy shares in an illiquid, private company. As I watched each founder and operator (e.g., COO/Chief of Staff/Head of HR) struggle with this problem, I realised that we need to come together if we want to stop reinventing the wheel and/or making decisions we will come to regret later. I sent the idea around to my network, and received hugely positive feedback. Thus, this blog series was born.

Over the next few weeks, we’ll go over:

1. History of Options in New Zealand and why you need them (this post!)
2. What we’re seeing in the market so far here in New Zealand
3. What might be best practice and the impact on employees, companies, and the broader innovation ecosystem
4. How to understand your ESOP package from the employee perspective

Options - Kiwis were slow to the party

Thanks to Andrew Simmonds of Simmonds Law Limited for providing this section!

In overseas markets, and in the US in particular, options have long been considered a standard part of your remuneration package at a startup. Over many years, market practices have developed for the terms of startup ESOPs, including the grants made to different levels of employees at different stages of a company’s development.?

Of course, there is some variance from company to company, and common practice adapts over time in response to market forces.?However, broadly speaking, the overall approach to ESOPs is pretty standard.?

In contrast, ESOPs were not in wide use amongst Kiwi startups prior to 2013, mainly because it was difficult to offer share options or other types of equity incentives employees (other than the top few executives of the company) under NZ’s old Securities Act.??

To bring New Zealand into line with international practice, the 2013 Financial Market Conduct Act introduced a broad exemption for employee share schemes modelled on the US equivalent (Rule 701).?Kiwi startups were quick to take advantage of the new rule, but there was a lots of variation in the types of schemes adopted.

From 2013 to 2019, quite a few companies implemented share purchase schemes as opposed to share option schemes for their employees.?Each employee’s share purchase was typically funded by a limited recourse loan from the company, which allowed the employee to repay the loan in full by giving the shares back to the company (regardless of the value of the shares).?

The aim of the share purchase schemes was to enable employees to treat the increase in value of the shares as a non-taxable capital gain.?However, in 2019 the IRD updated the rules for the taxation of employee share schemes in order to stamp out this type of scheme.?Since then, there is unlikely to be any tax benefit for using a share purchase scheme but plenty of downsides.

The relative novelty of employee share schemes, and the potentially different tax treatment of share option vs share purchase schemes, caused a lot of confusion amongst Kiwi start ups.?Some of this confusion has continued, even though ESOPs (as opposed to a share purchase scheme) should be the default position for almost all startups.

So if it’s all so confusing, why bother with an ESOP?

In talking to founders and VCs, a common thread emerged: a lot of work and a lot of uncertainty. If they add so much administrative overhead, why would a company bother with offering an ESOP at all? It comes down to Performance, Recruitment, and Retention.

Performance

Fundamentally, a stock option is a chance to buy a share in the business, which would make the employee a partial owner of the company. For me, it all comes down to that ownership mentality. Employees should constantly be asking themselves “what would I do if it were my company? Could we be doing things better?” If you own shares in it, it is partially your company, and I don’t know many business owners that walk away from major problems the second the clock strikes 5 PM.

Stock options should align incentives. If the company does well, we each individually do well and share in the returns. And if the company does really well, the growth in the value of your stock options will far outstrip the growth in your salary. The fastest way to watch your remuneration grow is to work on increasing the value of your shares, and having this kind of incentive can help you recruit the right, high-performing team that cares about increasing the value of the business as a whole.

Before we get too far, I need to remind you that most employee startup options are most likely to be worth somewhere between zero and not very much. But for a handful of lucky and hard-working earlier employees at the companies that make it big, they can produce life-changing returns. For many, that’s a big part of the dream of working hard to build something from the ground up and riding the roller coaster of hypergrowth at a startup.

Recruitment

ESOPs help startups compete in the war for talent, since they provide a tangible potential financial upside (high risk, high reward) compared to working for a higher salary at a more established business (lower risk, lower reward). Currently, many Kiwi startups seem to be recruiting on the basis of “culture” alone. While I love that Kiwi Startups constantly think about how we can work together better, relying on this as our biggest recruiting lever runs the risk of overemphasising innovation on the employee experience for the sake of innovation, as opposed to innovation on the business and product.

Stock options can offer an additional employee value proposition, and that changes over time. At very early startups, early employees sometimes take options in lieu of a salary (sweat equity). Since the business is worth very little at the time, they get large grants of options, commensurate with the risk and low cash salary they are taking. These are the employees that can experience life changing outcomes if the startup is even moderately successful. As businesses grow, the risk reduces and the option grants get smaller (i.e. $50000 of options will entitle the employee to buy 50,000 shares if the share price is $1.00, but only 500 shares if the strike price is $100). The rewards from this won’t usually be life-changing for most employees, but they still provide motivating upside (e.g., not enough money to retire on, but enough money to start angel investing).

At any stage, options serve as an important remuneration negotiation lever, especially for recruiting executives and other senior employees,. When your startup is successful, the stock options might be worth more than the cash remuneration, which brings us to retention.

Retention

Working at a growing startup can feel like working at a different organization every single year, and the people who are able to grow with the company, share institutional knowledge, and contribute to its continued success are invaluable. Unfortunately, your competitors would like to have them on their teams as well, and the continuous change can be unsettling to even the most resilient of employees. You need to give your employees a reason to stay, even when they can no longer be across every decision and know every person in the company.

I’m no expert in how to retain employees, and stock options are only a small part of employee retention, but a Silicon Valley adage goes “Always Be Vesting” – stock options or restricted stock units are often the golden handcuffs that keep people there through the long nights and difficult periods of change. This is why many companies also offer refresher grants to employees who stay for more than a certain amount of years.

Coming up

Now that we’ve established why you need to have an ESOP, we can get into how to structure it. Next week, we’ll be going through the results of a survey of 21 Kiwi start-ups and how they approach grants, exercises, and options terms.

Thanks for Contributing!

I’m very grateful to these wonderful people in the Kiwi startup ecosystem for helping share the survey (coming next week!) around and providing their insights and feedback:

• Kelcey Braine and the Creative HQ community
• The General List community
• Sacha Judd, Hoku
• Kirstie Marsh
• Andrew Simmonds, Simmonds Law Limited
• The Startmate community
• Keegan Vivian-Greer, Orchestra
• Sam Wong, Blackbird