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Crafting your ESOP: Key terms and best practice
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Here are the key ESOP elements and terms we most commonly see across our 100+ portfolio companies.

If you’re putting together an Employee Share Ownership Plan (ESOP) for the first time, you’ll probably find yourself asking: “How big should my option pool be?” or “What vesting schedule should we go with?”. 

While ESOP differs from one startup to the next, rather than guessing and checking as you go, we’ve put together a rundown of the key elements and terms. We’ve flagged (🌳) what we most commonly see across AirTree’s portfolio as a guide for each of these terms.

Plan type by company stage

There isn’t a one-size-fits-all ESOP structure. ESOP plan types typically differ by company stage and context. 

🌳 Here are the plan types we typically see:

  • Early-stage startups tend to default to ESOP with Start-Up Tax Concession due to the CGT benefit. 
  • Growth stage startups that are <10 years old and <$50m turnover use ESOP with Start-Up Tax Concession. For those startups that are >10 years old or >$50m turnover, they use ESOP with a strike price ≥ FMV, or ZEPOs with performance rights.
  • Later stage startups will use ESOP with a strike price ≥ FMV. Alternatively, they’ll use ZEPOs with performance rights, or a small allocation.

Check out our Open Source VC resource on choosing the right employee share scheme structure for your startup for more information.

Option pool size

A startup’s option pool is the portion of equity it may issue as share options to employees, consultants, directors and advisors in the future. This allows existing shareholders to know and agree to the potential dilution that could occur due to the options pool. 

The option pool size is expressed as a percentage of the total number of fully-diluted shares. Fully diluted shares refer to the total number of shares issued by the company, plus all shares that could be issued on the exercise or conversion of all convertible securities issued by the company (which includes all allocated and unallocated ESOP options, as well as any SAFEs or convertible notes).

🌳 The option pool size is typically 10-15%. Outlier scenarios include:

  • >20%: to incentivise a professional management team post spinning out from another company; more mature companies that have experienced higher levels of founder dilution.
  • <10%: company has recently raised a large round at a high valuation; unallocated pool still healthy.

Strike price

An ESOP's strike price determines the price at which employees can buy shares under the terms of their share option grant. 

It’s set at the time of grant, representing the price the employee must pay to exercise their vested options in order to convert them into actual shares in the company.

Strike price discount to last raise

The strike price of an employee’s options is frequently set at a discount to the share price at which a company last raised money from investors. 

A strike price discount to the last raise is typically used in instances where you have different share classes, that are higher ranking and/or have more favourable terms (e.g. preference shares vs ordinary shares). 

🌳The strike price discount to last raise is generally 30-40%. Outlier scenarios include: 

  • 90-100%: early-stage companies that qualify for the NTA methodology.
  • >50%: companies that have raised large rounds (higher preference share stack) at high multiples.
  • No discount: single share class (i.e. ordinary shares only with no preference shares), or to foster complete alignment with the last money in. 

Vesting

Vesting period

The vesting period is the amount of time an employee must be full time employed by the company for their full option grant to be exercisable into shares.

🌳 The vesting period is typically 4 years. Shorter vesting periods are sometimes used for top-ups where an employee has graduated into a new role or as a performance bonus in lieu of cash. 

The cliff

The cliff denotes the initial period of time in which share options don’t vest. It’s common for companies to withhold option vesting for the first year, as this allows them to identify any mis-hires without facing dilution of company equity. 

🌳 1 year cliff. 

Under a 1 year cliff, no options vest until the one-year anniversary of the grant. At the one-year anniversary, a full year’s worth of options vest in a single tranche. Alternatively, if the employee decides to leave before the one-year mark, they lose all unvested options. For top ups, we don’t usually see a cliff as the employee is a known performer by that stage. 

Vesting schedule

The vesting schedule describes the rate at which share options will vest over the vesting period. Two common vesting schedules are linear and back-ended. 

A linear vesting schedule is where the same amount of options vest over the vesting period. For example, under a 4 year vesting period with an annual vesting cadence, 25% of the option grant will vest each year.  

In a back-loaded vesting schedule, the employee gets a smaller amount of their grant at the beginning of the vesting period, accelerating to a higher percentage towards the back end of the vesting schedule. For example, 10% in the first year, 20% in the second, 30% in the third and 40% in the fourth. 

🌳 A linear vesting schedule is standard practice in Australia.

A back-loaded vesting schedule is becoming more common for later-stage, US and EUR companies as they seek to incentivise longer-term tenure and contribution, and discourage job hopping after 1-2 years.

Traditional vs. back-loaded vesting schedule

Vesting cadence

The vesting cadence refers to the frequency at which options vest, typically monthly, quarterly or annually. 

🌳Following a one-year cliff, we commonly see a monthly vesting cadence. Quarterly and annual vesting cadences are also popular as they are another way to encourage retention, particularly under a linear vesting schedule. 

Monthly vesting cadence with 1 year cliff

Performance-based vesting

Performance-based vesting ties the vesting of options to certain performance goals, including:

  • Individual performance
  • Company performance
  • Fundraising or liquidity event

It’s used to align the interest of employees, most commonly at the executive level, with the company's success. 

🌳 Performance-based vesting is uncommon at early-stage startups (typically time-based vesting only). More commonly used by growth and later-stage companies under the following circumstances:

  • ZEPOs, or heavily-discounted options
  • Key exec hires and top-ups
  • Founder participation and top-ups
  • To incentivise a near term term fundraising or liquidity event

Change of control and accelerated vesting

Your ESOP plan will outline what happens to employee options if a change of ownership occurs (i.e. a merger, acquisition or IPO).In most cases, ESOP plans require vested share options to become exercisable. 

In an acquisition, the new owners purchase vested “in the money” options under the same terms offered to all shareholders, whether that’s cash, shares in the new company or a combination of both. Unvested and “out of the money” options lapse. In its place, an acquirer typically puts in a new retention programme for key employees.

Conversely, during an IPO, shares from exercised options become tradable shares in the listed company. Unvested options will generally continue to vest following the IPO.

To ensure flexibility for different exit outcomes, accelerated vesting provisions are typically at the discretion of the board.

Providing broad-based acceleration to all option holders is uncommon for two reasons. Firstly, it reduces the sale proceeds for existing shareholders. Secondly, it may hinder the chances of a successful exit. Your team is a valuable asset to the acquiring company. If a significant portion of the team stands to make additional upside at the point of acquisition, the risk of them leaving increases significantly. 

Exceptions are sometimes made for key executives who are critical to the success of an exit. Without acceleration rights, there may be an incentive to delay a sale process until their options are fully vested. 

In these cases, a double-trigger acceleration provision is typically in place, requiring both a change or control and an employee's involuntary termination or demotion to come into effect. This protects against new owners who may terminate - or effectively terminate - the role of key employees to prevent them from vesting additional options.

🌳 Accelerated vesting is typically at the discretion of the board, and only offered under the following conditions:

  • Key execs only
  • Partial vesting, not full (i.e. 12 months max)
  • Double-trigger acceleration

Exercisable period

The exercise period is the time frame in which an employee can exercise their right to purchase vested share options from the company. 

The ability to exercise options has historically been split between At Exit or When Vested

🌳 We recommend exercise At Exit for tax efficiency (i.e. deferred tax status). We’ve covered the tax implications associated with different ESOP structures here.

Good and bad leavers

Good leavers

Good leaver provisions refer to scenarios where employees leave due to reasonable circumstances or reasons outside their control (e.g. retirement, redundancy or illness). 

When a good leaver event occurs, all of the employee’s unvested options will automatically lapse, and their vested options are generally dealt with in one of the following ways:

  • They’re entitled to hold onto their options until they’re exercised (generally restricted to an exit);
  • They’re required to sell their options to a third party determined by the board; or
  • They’re required to exercise their options within a certain period (normally 90 days).

If the employee is required to sell their vested options, the sale price is usually the fair market value (FMV). The default position in early-stage startups is the board determining FMV. Alternatively, the board will appoint an independent 3rd party to determine FMV.

🌳 We usually see good leavers entitled to retain their options until exercised on exit. Forced exercise within a certain period is more common in US companies due to tax reasons. Requiring to sell to an endorsed third party is less common and usually only where the Founders and Board have a higher need for control over the cap table.

Bad leavers

Bad leaver provisions refer to scenarios involving an element of fault on behalf of the employee (e.g. the employee is fired for committing fraud or another criminal offence, seriously breaches their employment agreement, or breaches a non-compete). Bad leaver provisions need to be a sufficient deterrent.  

If a bad leaver event occurs, all of the employee’s unvested options will automatically lapse, and vested options are generally dealt with in one of the following ways:

  • The vested but unexercised options automatically lapse (similar to unvested options); or
  • Vested options must be transferred to another party as determined by the board or bought back and cancelled by your company, often at a discount to FMV (e.g. the employee only receives 50% of the FMV of their options, less the strike price).

If the employee has exercised any options, and holds shares, depending on the severity of the bad leaver event, your company may also include a forced transfer or buy-back right for those shares, also at a discount to FMV (e.g. the employee only receives 50% of the FMV of their shares).

🌳We most commonly see the vested, but unexercised options automatically lapse.

Employee share trusts

A lot of companies set up ESOP trusts, which are trusts specifically established and operated to hold the legal title to the shares issued to ESOP participants (either directly or on exercise of options). Often the company will set up a subsidiary that acts as the trustee of the ESOP trust, and the relevant employees are the beneficiaries in respect of their ESOP shares. 

ESOP trusts are primarily used to ensure the company can maintain the number of its shareholders below 50 (the point at which additional compliance and regulatory obligations will be imposed on the company). ESOP trusts are also useful in streamlining corporate governance and administration, as the beneficiaries will often appoint the trustee or the directors/founders of the company as their attorney and proxy to exercise the voting and approval rights of the ESOP shares. Other than voting rights, ESOP trusts are generally structured to ensure employees maintain their rights in respect of their shares (including information, dividend, and transfer rights). 

Open Source VC – ESOP Advisors

Has an advisor helped you out with your ESOP? Pay it forward and share their details in our Open Source VC list.

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This post contains general information only. You should seek financial or tax advice to take into account your personal circumstances before acting or relying on this information.
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