Why I Chose to Implement ESOP at Integral: Beyond the Balance Sheet
We are pleased to present a unique feature on our blog today. The following post comes courtesy of a guest contributor, Collective 54 member Ashok Sivanand, CEO @ Integral. We are honored to share his knowledge and viewpoints with our readers. Enjoy this unique piece that broadens the horizons of our usual content.
During my time at Shoplogix and Pivotal Labs, I experienced the transformative power of Employee Stock Ownership Plans (ESOP). While the outcomes for me were moderate at-best, (think downpayment on a house), I was fortunate to have experienced this first-hand on my journey to founding Integral.
Witnessing how ESOP reshaped the workplace was enlightening – it felt more than business strategy. It was a catalyst for a more engaged and vibrant company culture. Compared to my time at larger enterprises, I clearly felt and experienced increased employee commitment, a surge in tenacity, and a strong sense of belonging among employees. This wasn’t just about numbers; it was about nurturing a workplace where everyone feels invested and accountable to our collective success.
My close interactions with the founders offered me a unique perspective on the intrinsic value of ESOPs and how they help bridge the typical divide between shareholder and employee. ESOPs create a shared sense of purpose and success, transforming every team member into a stakeholder in our collective journey.
The Viability of ESOP in Professional Services
Implementing ESOP in a professional services setup isn’t always a straightforward path. Similar to how Collective 54 has a pro-serve specific model to EOS (Entrepreneurial Operating System), ESOP demands tailoring the popular models catered to product companies to fit our industry dimensions
Considerations at the Forefront
Here are some of the top considerations we had to confirm in order to confidently implement our program.
- Intent of Business: Decide early whether you’re running a lifestyle business or growing a scaled business. It’s my opinion that an ESOP makes a lot more sense for the latter.
- Structural Choices: While it’s more straightforward to implement the program for a C-Corp, there are various approaches like phantom stock that can help achieve the same goals for an LLC.
- Vesting Strategies: Consider whether vesting happens based on time (eg. 4 years), performance, or some combination. Time-based vests are a lot simpler to implement and will likely work for most cases.
- Ownership Percentages: Decide early what percentage of the business you want to allocate to the stock option pool. Since you can always allocate more shares in the future, i’d recommend starting small. We started with 15% with the intent of adding another 15% as we grow.
- Compensation Balance: Generally, stock options allocations follow similar proportions as salary allocations. The % of upside an employee might receive from the equity versus their salary increases as the employee is more senior.
- Stage of the Firm: In the earlier days, when cash was tight and we couldn’t afford to pay market salaries, we allocated higher values of stock options. As we grew, we adjusted to market compensation and reduced the stock option allocation per employee.
- Managing Exits: Plan for scenarios like key employees leaving and be transparent about it. I have witnessed peers end up in wasteful legal battles with senior executives leaving and trying to take them off the cap table.
- Dividends for Alumni: If you choose to pay out dividends, you’ll have to decide early whether alumni shareholders get paid those dividends. Like the point above, this can seem difficult, especially if the alumni left on bad terms. My advice is to remind you that you set out to build something great. Channel that emotional energy toward solving meaningful problems and serving more people and chalk these payments up to “dumb taxes” as the Collective 54 members call it.
Implementing ESOP: Legal and Practical Learnings
- Choosing the Right Law Firm: It’s crucial to work with a firm that has experience with this. My initial struggle with a non-specialized firm led to high costs and no results, whereas a specialized firm in Palo Alto was more efficient and cost-effective. The initial cost was $3,500 with the right firm.
- Options Galore: There’s a variety to choose from, like ISO/NSO. At the bottom of this post, I have attached a table prepared by my legal firm in 2017. I would advice legal and tax consult to confirm this information is still relevant before taking action. Deciding between options is more about aligning with your company’s values and principles than just logic or math.
Operationalizing the ESOP Program
- Educating Employees: We observed a trend where many colleagues either undervalued or overvalued their stock options. Addressing this through regular education sessions and transparent communication about valuations has been key.
- Encouraging Voluntary Participation: We’ve been cautious not to sway employees towards participating or create a divide between those who exercise their options and those who don’t. It’s tempting to use future valuations as a significant part of compensation, but this should be approached carefully based on the factors mentioned above.
- Attracting Talent: Interestingly, some colleagues were drawn to our firm because of the stock option program, resonating with their own values and aspirations to be part of the firm’s growth trajectory. They chose us over competing offers and marginally higher compensation for the value alignment.
- Maintaining Transparency and Fairness: We emphasize transparency in our operations but also respect privacy by keeping shareholder identities confidential and ensuring equitable treatment.
- Tools for Efficient Management: I highly recommend software tools like Capshare or Carta for managing ESOP programs and your annual valuations (409A). These tools offer efficiency and clarity in administration.
Implementing an Employee Stock Ownership Plan in a professional services firm is more than just a strategic decision; it’s a transformative journey towards collective growth and success. ESOPs offer a unique opportunity to align the interests of your employees with those of the company, creating a powerful sense of ownership and shared destiny. This alignment not only enhances engagement and commitment but also drives innovation and performance, as every team member becomes an integral part of the firm’s success story. As you grow and evolve your firm, consider the profound impact that an ESOP can have. It’s not just about sharing financial success; it’s about fostering a culture of unity, motivation, and collective achievement. Embrace this opportunity to not only grow your business but to also enrich the lives of those who contribute to its growth. Let the journey of ESOP be your firm’s stepping stone to new heights of success and fulfillment.
| Corporation | Corporation | LLC | LLC | Corporation/LLC | |
| Incentive Award | Incentive Stock Option (ISO) (early exercisable) (employees only) | Non-qualified Stock Option (NSO) (early exercisable) | Option to purchase common LLC Unit (early exercisable) | Profits Interest | Cash Incentive Program |
| Mechanism | Employee is granted an option to purchase shares of the Company’s common stock in the future, exercisable immediately but subject to vesting based on continued service to the Company. | Person is granted an option to purchase shares of the Company’s common stock in the future, exercisable immediately but subject to vesting based on continued service to the Company | Person is granted an option to purchase units of the Company’s common equity in the future, exercisable immediately but subject to vesting based on continued service to the Company. | Employee is granted an interest in the Company’s future profits and losses, which may or may not be distributed to employee depending upon operating income and tax distributions. May be subject to vesting. | Program allows for grant of specified number of units, and each participant is granted a number of units, which may or may not be subject to vesting. Payment on units made on change in control only. |
| Documentation | Stock Option Plan, Notice of Grant, Option Agreement and Exercise Agreement. | Stock Option Plan, Notice of Grant, Option Agreement and Exercise Agreement. | Equity Option Plan, Notice of Grant, Option Agreement, Exercise Agreement, Operating Agreement | Equity Incentive Plan, Profits Interest Agreement, Operating Agreement | Cash Incentive Program and Award Agreement |
| Exercise Price | > FMV at grant | > FMV at grant | > FMV at grant | N/A | N/A |
| Individual’s Tax Treatment | Taxed only on sale of shares acquired upon exercise of option. If holding period is met, difference between sale price and exercise price is taxed at long-term capital gain rates. Holding period = 1 year from exercise & 2 years from date of grant *Spread at exercise may be included in taxable income for purposes of determining AMT. | Taxed at exercise at ordinary income rates on difference between exercise price and FMV on exercise date assuming 83(b) election is made. Additional tax upon sale at capital gain rates on difference between FMV on exercise date and sale price. | Taxed at ordinary income rates when units are issued upon exercise on difference between exercise price and FMV on exercise date. Taxed on date of sale at capital gain rates on difference between FMV on exercise date and sale price. | Taxed annually when profits/income is allocated to profits interest holders. Allocation of profits to profits interest holders may occur only if certain thresholds are met. | Taxed only upon payment in connection with a Change in Control. Taxed at ordinary income tax rates when cash is received. |
| Treatment upon Change in Control | Unexercised awards (or exercised but unvested awards) will accelerate immediately prior to CIC unless otherwise assumed or substituted by acquirer. Holders of vested shares will receive same consideration if, when and as other stockholders are paid. | Unexercised awards (or exercised but unvested awards) will accelerate immediately prior to CIC unless otherwise assumed or substituted by acquirer. Holders of vested shares will receive same consideration if, when and as other stockholders are paid | Unexercised awards (or exercised but unvested awards) will accelerate immediately prior to CIC unless otherwise assumed or substituted by acquirer. Holders of vested units will receive same consideration if, when and as other stockholders are paid | Paid out in accordance with terms of Operating Agreement (generally will convert into right to receive a cash payment at closing, subject to the threshold and any senior equity rights. | Each unit represents the right to receive a cash amount equal to X% of the consideration paid to the Company’s owners in connection with a Change in Control, if, when and as paid to the stockholders. Program is treated as a liability that is paid out before the stockholders receive consideration for their equity. |
| Treatment upon IPO | Full stockholder rights upon exercise of option. (Vested shares are freely tradeable.) | Full stockholder rights upon exercise of option. (Vested shares are freely tradeable.) | N/A (unlikely that entity would go public as LLC) | N/A (unlikely that entity would go public as LLC) | No payment is made without a change in control. |
| Treatment as Stockholder/ Member | Full stockholder rights upon exercise of option; provided that unvested equity can’t be transferred. | Full stockholder rights upon exercise of option; provided that unvested equity can’t be transferred. | Full member rights upon exercise of option; provided that unvested equity can’t be transferred. Eligible for tax distributions. | Full member upon grant of profits interest, regardless of vesting (provided that unvested equity can’t be transferred). Eligible for tax distributions. | No |
| Treatment as Employee | Yes | Yes | Prior to exercise, yes. Following exercise, treated as partner, and the employee-partner will be responsible for paying the employer portion of his/her own employment taxes (FICA, Medicaid, etc.). Any benefits paid for by the company (e.g., medical benefits) cannot be provided on a tax-free basis. | Immediately after grant, treated as partner and the employee-partner will be responsible for paying the employer portion of his/her own employment taxes (FICA, Medicaid, etc.). Any benefits paid for by the company (e.g., medical benefits) cannot be provided on a tax-free basis. | Yes |
| Tax Reporting | Form 3921 regarding exercise of option must be distributed by company to employee in the year following year of exercise. If option is exercised for unvested shares, Section 83(b) election must be filed by employee with IRS within 30 days of exercise. | If option is exercised for unvested shares, Section 83(b) election must be filed by employee with IRS within 30 days of exercise. Income at exercise reported by company on W-2/1099. | After exercise of option, Form K-1 must be distributed annually to partner detailing partner’s shares of profits and losses for each fiscal year. If option is exercised for unvested Units, protective Section 83(b) election should be filed by employee with IRS within 30 days of exercise. | Form K-1 must be distributed annually to partner detailing partner’s shares of profits and losses for each fiscal year | Form W-2 will report income earned in transaction as compensation. |
| Effect on Entity Tax Treatment | No effect on entity tax treatment. | No effect on entity tax treatment. | Prior to exercise of first option or sale of equity to another third party, entity is treated as sole proprietorship. Once first option is exercised or equity is sold to a third party, entity is treated as partnership. A new tax ID may be required. Partnership tax returns are then required. | Prior to first grant, entity is treated as sole proprietorship. Following first grant of a profits interest, entity is treated as partnership. A new tax ID may be required. Partnership tax returns are then required. | No effect on entity tax treatment. |