When ESOPs go pear-shaped and how to prevent it from happening to you

Employee Share Options Plans (ESOPs) are proven as a powerful tool for aligning the interests of employees with those of the company, fostering a sense of ownership, and promoting long-term success while giving your team ‘skin in the game’. However, like any complex financial instrument, the way an ESOP is structured and presented to the team can vary hugely from company to company, and they also come with their share of challenges and potential pitfalls. Here are the top five ways an ESOP can go wrong and how you can prevent it:

1. Poor communication and education:

• One of the primary reasons ESOPs may fail is a lack of clear communication and education. If employees do not fully understand the plan, its benefits, and their role in its success, it can lead to dissatisfaction, confusion, and mistrust. 
  

• Companies must invest time and resources in effectively communicating the details of the ESOP to ensure that employees are informed and engaged. This might include an initial training session for new employees and regular updates on how the business is tracking and how that might affect the company ESOP.

2. Inadequate governance and management:

• Effective governance is crucial for the success of an ESOP. In some cases, companies may experience issues when there is a lack of transparency, accountability, or oversight. Poor management decisions or lack of strategic planning  can erode the value of the ESOP, leading to disillusionment among employees.
  

• This can be addressed by having a clear and concise ESOP strategy from your board of directors. You may wish to seek external advice from a lawyer, advisor or someone you trust that has experience in ESOP to help inform key variables.

3. Market volatility and economic downturn:

• Economic conditions and market volatility can significantly impact the value of a company's shares, directly affecting the value of ESOP participants' share options. In times of economic downturns or market instability, the value of the ESOP can decline, potentially resulting in dissatisfaction among employees who may see a reduction in the value of their current or future ownership stake. Companies need to consider the broader economic context and implement risk mitigation strategies to navigate such challenges.
  

• Some businesses choose to issue share options to employees at a lower than fair market value so that they are ‘in the money’ on day one (if local regulations allow them to do so). In addition, it’s important to be realistic about the share value so that employees aren’t disappointed or disillusioned in the case of a share price reduction.

4. Valuation challenges:

• ESOPs can sometimes require a regular valuation of the company's shares to determine the value of participants' shares. Valuation challenges can arise from inaccurate assessments, especially in industries with fluctuating market conditions or unique business models. If the valuation process is not conducted meticulously, it can result in discrepancies, dissatisfaction among employees, and potential legal issues.
  

• In some countries such as the US and UK there are regulated methodologies to value company shares as they relate to an ESOP (409A and HMRC valuations respectively). However, most startups in Australia and New Zealand do not require a regular valuation, instead, a company will typically rely on either a recent share transaction (transfer or share issue), an external valuation from appropriate service provider or most commonly, they will create and agree upon an internal calculation that establishes the FMV (fair market value) of company shares. Noting that different business types and industries will have different valuation calculation methods, for example a revenue multiple is common for software companies vs EBITDA being more relied upon in food and beverage etc.

5. Lack of exit strategy:

• ESOPs may encounter problems when there is no clear company exit strategy in place, or an agreed upon way for employees to sell their shares (after exercising) such as share trading windows. Without a well-defined exit strategy, the company may face difficulties managing ownership transitions, potentially leading to disputes and challenges in sustaining the ESOP over the long term.
  

• It is a worthwhile exercise to consider the timeline of a potential exit or liquidity event and make that known to ESOP participants. In addition, to have an ‘employee-friendly’ ESOP you may consider extending the expiry of share options. Finally, some companies will have windows where employees can exercise and trade their options which allows for liquidity.

In conclusion, while ESOPs can be a powerful tool for fostering employee engagement and ownership, they are not without risks. Companies must be diligent in their planning, communication, and management to navigate potential pitfalls successfully. It’s important to be up-front and honest with employees, while also making sure that they are aware of the risks associated with being an ESOP participant or future shareholder. A well-executed ESOP, supported by effective governance and strategic decision-making, can provide lasting benefits for both employees and the company alike.

Another consideration to take into account is the way in which share options are treated when an employee departs. Keep an eye out for our next blog post that covers key information such as good leaver/bad leaver scenarios, short vs long expiry dates and forced share sales too.

It’s important to work with a good lawyer/advisor to make sure your company ESOP is fit for purpose.