What is an ESOP? Stock grants vs Stock options


This is a stock-based compensation plan offered or granted to employees by companies, with the main objective of attracting, retaining and motivating talents whose services are considered highly valuable, thus fostering the sense of belonging of such individuals, and stimulating their active interest in the development and success of the company.


Specifically, the ESOP is a tool widely used by startups, as it allows them to attract quality human resources, which would otherwise be impossible for them because they cannot afford to pay salaries competitive with the rest of the market. Through this tool, these employees feel attracted to the project, having the possibility of betting and contributing to its success, in order to obtain a return before a future IPO or sale of the company.


Within each ESOP, it is possible to determine which instrument is used to compensate employees, according to the needs and characteristics of each company. Specifically, in this publication we will focus on differentiating Stock Grants from Stock Options, highlighting the main characteristics of each of these instruments.


What is the Vesting and Cliff period? Before analyzing the differences between Stock Grants and Stock Options, it is convenient to keep in mind the following concepts as they will be applicable and relevant to both instruments:


Vesting:

Vesting is the process by which a person acquires rights to something, in this case to company shares. In the context of vesting, these rights are not obtained immediately, but are gradually released or consolidated as certain conditions previously agreed with the company are met. 

In startups, the condition for the founders to obtain the rights to the shares is usually the passage of time, commonly known as the "vesting period". Other conditions may be established, such as, for example, the fulfillment of certain turnover milestones.

Taking into account the above, the vesting scheme commonly used by startups is a vesting period of 4 years, whereby the person obtains the rights to the total shares at a rate of 25% per year. At the end of the 4-year vesting period, the person will have consolidated rights over 100% of the shares granted. Likewise, this is not the only scheme and others may be agreed, depending on the characteristics and needs of the company.

Within the concept of Vesting, there is a derivation that is also widely used by startups, which is called Reverse Vesting, and that unlike conventional vesting, all the shares are already owned by the person from the beginning and in case of not reaching the agreed minimum period of permanence, will be obliged to transfer to the other partners or to the company itself (depending on what is agreed) those shares that have not been consolidated.

As we have mentioned, vesting is one of the tools used within the ESOP to achieve the permanence of key employees and motivate them to achieve the success of the company. Vesting is also widely used among startup founders, as it often serves as a guarantee to investors that they will remain in the company for a certain period of time.


Cliff Period:

This is a period of time during which the persons included in the vesting must remain in the company in order to consolidate or obtain rights to the shares. If the person leaves the company before the Cliff Period has elapsed, he/she will not be able to dispose of his/her shares at all.

Following the scheme commonly used by startups and mentioned above, it is usual to grant a Cliff Period of 1 year within a vesting period of 4 years. In other words, if the employee stops providing services within the first year, he/she will not receive any shares in return. On the other hand, if the employee remains in the company after the first year has expired, he/she will earn the first 25% of the shares and then the remaining percentage according to the vesting schedule. In the event that the employee ceases to render services after the Cliff period has expired, he/she will keep only the "vested" shares until that date.


Stock Grants vs Stock Options


These are two instruments that may be envisaged within the framework of an ESOP, with the main objective of retaining and attracting talent in a company. However, we believe it is important to differentiate between them as they have different implications for the beneficiaries.


The main difference between the two instruments is that in the case of Stock Grants, shares are granted directly to an employee in exchange for services rendered in the company, unlike Stock Options, in which an option (not an obligation) to purchase shares is granted in exchange for a determined price and to be exercised within a determined period.


As mentioned, such call option is granted through a document called Award, which establishes the Cliff period, the vesting period, the exercise Price and the exercise Period. We have already delved into the concepts of Cliff and Vesting, so it is necessary to go deeper into the Exercise Price and Exercise Period.


Exercise Price:

Basically, it is the fixed price at which the employee is granted the option to purchase a certain number of shares. Therefore, the beneficiary of this option must pay a fixed price to exercise the option and acquire the shares. This fixed price is generally lower than the market value or commonly called Fair Market Value ("FMV") and is granted as a benefit under the ESOP. The real benefit comes from the fact that the beneficiary of the option has access to a certain amount of shares at a lower price and will be able to dispose of them in the future at market value, thus obtaining a real gain. In the event that the FMV is lower than the exercise price, the beneficiary will have the possibility of not exercising the option granted, speculating that the FMV will increase again and be able to sell his shares to obtain a profit.

It is important to bear in mind that the exercise price will be maintained over time and cannot be modified during the Exercise Period, which provides certainty to the beneficiary of the option.


Exercise Period:

This is the period within which the purchase option may be exercised at the previously fixed price. This period is usually 10 years. After this period, the option is revoked and the beneficiary of the option will not be able to acquire the shares.


In order to differentiate between the two instruments, it is important to point out and emphasize that, through the Stock Grants, the employee is directly granted a number of shares in exchange for the provision of services in the company, without having to exercise the option and pay a price in exchange. The foregoing is without prejudice to the establishment of a Cliff and vesting period, since once these are fulfilled, the employee will have consolidated the rights directly over the shares.


On the other hand, through the Stock Options instrument, as its name indicates, what is granted is an option, which may or may not be exercised by the employee, and in the event of exercising it, the employee must pay a price in exchange for the shares, which will be previously fixed.


We understand that, in these times, the aforementioned differentiation takes on greater relevance, since many startups are contemplating this compensation tool to attract talent, and it is often confusing for them to determine which instrument to use to implement it. In general terms, the Stock Grants instrument is used in companies in the midst of growth, with little trajectory and no real valuation. On the other hand, the Stock Options instrument is used in the case of mature companies, with a real valuation or even listed on the stock exchange, in which employees are willing to pay a price in exchange for obtaining shares in them, in order to speculate on the price increase and obtain a profit in the future.