How to Set Up an Employee Stock Option Plan (ESOP) That Scales with Your Startup

As a growth-stage startup competing with established companies, equity is your secret weapon. A well-designed employee stock option plan (ESOP) can shift your compensation strategy from a mere cost center into a powerful magnet for top performers eager for ownership in your company's future.

As your startup scales from seed to Series A and beyond, your ESOP becomes the bedrock for recruiting executives, retaining key contributors, and building a culture of shared ownership. It also allows you to manage dilution and preserve operational flexibility.

Understanding employee stock option plans (ESOPs)

An ESOP is far more than just a compensation tool for startup founders. It's a strategic framework that underpins talent retention and long-term company alignment. It’s created and approved by your board and shareholders and governs how your company grants equity and outlines who is eligible. 

An ESOP also specifies the amount of equity your company may grant, the types of equity awards permitted (such as ISOs and NSOs), and the vesting, exercise, and expiration terms of those awards. It’s the rulebook that enables you to systematically and legally issue equity as your company scales.

In the early days, your ESOP might be as simple as a 10 percent option pool reserved for early hires. But as your company expands with new executives, advisors, and investors, it’s critical to your operational infrastructure. Your ESOP shapes hiring, compensation strategy, cap table modeling, and how you prepare for future financing or liquidity events.

How an ESOP works at the plan level

To effectively manage equity, you need to understand the mechanics of an ESOP. Aside from its strategic benefits, your ESOP functions as a structured legal framework for your equity grants. From a legal and operational standpoint, an ESOP has four key components:

1. Equity pool definition. The equity pool represents the number of shares set aside for future grants, typically expressed as a percentage of your fully diluted shares. Your initial pool size, often between 10 and 20 percent, requires approval from both the board and shareholders, with future increases generally requiring further sign-off. 

You'll find yourself regularly revisiting and adjusting this pool's size and structure, especially before significant financing rounds

2. Grant terms & plan rules. Beyond simply defining the total pool, the ESOP carefully outlines the mechanics of individual equity grants, specifying:

• Eligibility: The plan clearly defines who is eligible to receive grants, whether it's limited to employees or includes advisors and contractors.
• Type of equity: This specifies the various forms of equity awards allowed, such as incentive stock options (ISOs), non-qualified stock options (NSOs), or restricted stock units (RSUs), each with distinct tax and legal implications.
• Vesting schedules: The ESOP sets the terms by which equity gradually becomes exercisable. This process commonly follows a four-year schedule with a one-year cliff, but it can also include milestone-based vesting for specific roles or agreements.
• Exercise periods and post-termination windows: The plan outlines the specific timeframe during which recipients can purchase their vested company stock, along with the rules governing this process after employment ends.
• Repurchase rights and early exercise options: This outlines the company's right to buy back company shares under certain conditions, and whether employees have the option to exercise unvested options.

These complex details collectively form the backbone of every option agreement, establishing the core framework for how your team earns ownership over time.

3. Pricing and valuation compliance. Private companies must issue options at or above their fair market value, determined by a 409A valuation. An ESOP leverages these valuations to set compliant strike prices and avoid unnecessary tax liabilities for recipients.

4. Governance and amendments. An ESOP requires shareholder approval by the board of directors. Material changes, such as expanding the pool, adjusting vesting norms, or adding new award types, also require approval and documentation. Legal and finance teams manage compliance, while founders ensure the plan aligns with business needs. 

As companies mature, ESOPs often become more complex, incorporating RSUs, phantom equity, or multiple plan layers. But early on, your focus should be on maintaining flexibility while balancing dilution and team alignment.

What are incentive stock options (ISOs)? 

Incentive stock options (ISOs) can only be granted to employees and may offer favorable tax benefits if properly structured. When a recipient meets the required holding periods, any gains may qualify as long-term capital gains. 

Qualifying for long-term capital gains treatment can significantly reduce the recipient’s tax liability compared to being taxed at ordinary income rates. Long‑term capital gains taxed at 0, 15, or 20 percent offer significantly lower tax rates than ordinary income, helping to reduce overall tax liability.

ISOs are limited to $100,000 in stock that becomes exercisable per year, however, based on the stock’s value on the grant date. Any amount over that limit is treated as an NSO. They require a shareholder-approved ESOP and must adhere to specific exercise and expiration timelines to preserve their tax advantages.

From a founder’s perspective, ISOs are generally best suited for core full-time team members, especially early hires who prioritize long-term upside over short-term salary or a traditional retirement plan.  

What are non-qualified stock options (NSOs)?

Non-qualified stock options (NSOs) lack the tax benefits of ISOs but are less restricted. Companies may grant NSOs to employees, contractors, advisors, board members, and even vendors in some cases. Their flexibility makes them the workhorse of most ESOPs, especially as team structures grow beyond traditional W-2 roles.

As a general point of clarification, stock options are sometimes confused with stock warrants, though they differ in purpose, taxation, and issuance.

Unlike ISOs, NSOs do not qualify for favorable tax treatment. When the recipient exercises them, they pay income tax on the difference between the strike price and the fair market value. Additionally, your company may have a withholding obligation. ISOs and NSOs are often tax-deductible for the company when exercised.

Despite the different tax implications, NSOs are far easier to scale. They’re not subject to the $100K cap, nor do they require the same specific holding periods as ISOs, making them critical for offering equity to non-employees. 

However, NSOs trigger ordinary income tax at the time of exercise on the spread between the exercise price and fair market value, introducing additional tax complexity. They may also create more administrative overhead for growing companies—especially around valuation, reporting, and tax withholding.

Stock options vs. RSUs

While stock options are the dominant form of equity compensation in early-stage startups, RSUs become more relevant as you approach an IPO or acquisition. The shift occurs due to their simplicity, reduced employee risk with higher valuations, and alignment with public market and liquidity event needs.

RSUs don’t require the recipient to purchase the shares. Instead, they’re granted outright, typically on a vesting schedule, and convert into shares automatically. As a result, there’s no strike price and no exercise decision. However, their value is taxed as ordinary income upon vesting, regardless of whether the shares are liquid at that time.

For early-stage companies, RSUs are usually less attractive. They create tax liability without liquidity and hit your cap table immediately. But in later stages, when shares are more liquid and valuations are higher, RSUs provide the simplicity that many employees (and CFOs) prefer.

Designing your ESOP: What to prioritize as a growth-stage company 

As you design your ESOP for growth, every decision you make will impact your long-term success. Focus on key elements like option pool size, vesting schedules, fair pricing, and eligibility criteria.

Size your option pool for hiring and fundraising

Deciding your initial option pool size is a critical step. An option pool represents equity reserved for future grants to employees, advisors, and board members. For growth-stage companies, an initial pool typically ranges from 10–20 percent of fully diluted shares. 

Proper sizing strikes a balance between attracting top talent and managing dilution. You need enough options to incentivize key hires for the next 12–18 months and to present a clear equity strategy to prospective investors.

Set vesting schedules that retain talent

Vesting schedules can greatly influence employee retention by defining how and when an individual gains ownership of their equity. A common structure is four-year vesting with a one-year cliff: Employees gain no equity during the first year, but on the one-year anniversary, they receive the first 25 percent in a lump sum, with the remaining equity vesting monthly thereafter. This approach rewards long-term commitment and protects the company from early departures.

As an executive or strategic advisor, you might consider alternative, performance-based schedules. A good vesting strategy directly aligns employee incentives with your company's long-term success.

Price options fairly and stay 409A compliant

Correctly pricing your stock options is non-negotiable for compliance and key to attracting talent. To achieve this, private companies must issue options at or above their fair market value, as determined through an independent 409A valuation.  

Because a company's value can fluctuate, 409A valuations require at least annual updates and after material events like fundraising rounds. Accurate and current 409A valuations produce compliant strike prices, helping you avoid employee tax liabilities and mitigate company risks.

Define eligibility for new and existing employees

Your ESOP should clearly outline whether full-time employees, part-time staff, contractors, or board members are eligible for equity grants.

Consider grants for both existing employees and new hires, and determine whether they should receive refresh grants based on performance or promotion. A well-defined eligibility framework provides fairness and operational clarity for your HR and finance teams.

Setting up your employee stock option plan 

Once your ESOP design is complete, it's time to move into the setup phase. Seek an experienced legal counsel to draft the formal ESOP document, carefully outlining all rules and terms. The plan will then need formal approval from your board of directors and shareholders. 

You must also secure a 409A valuation, in which an independent firm determines your company’s fair market value and sets a compliant strike price for your options. Be sure you know the difference between common and preferred stock, as it will determine how stakeholders price, model, and perceive equity.

Getting a timely valuation will help you avoid significant tax and compliance risks. Your equity grants will be legally sound and ready for operation when you complete these steps. Pulley has supported hundreds of startups through this process, designing equity plans that grow with their team, cap tables, and investors.

Common mistakes in setting up your ESOP

While your employee stock option plan is a powerful tool, its effectiveness hinges on precise execution. These common missteps during setup can undermine your equity strategy:

• Underestimated pool: Failing to allocate enough options from the start
• 409A neglect: Ignoring regular valuations, risking tax penalties
• Vague documents: Ambiguous terms in the ESOP or grant agreements
• Poor communication: Insufficiently educating employees on their equity
• Manual management: Relying on spreadsheets for cap table updates
• Outdated plan: Not updating the ESOP in conjunction with company milestones

Proactively addressing these areas will strengthen your ESOP and protect your company's equity foundation. A well-executed ESOP empowers growth and talent, safeguarding your company's long-term vision.

How to manage your ESOP at scale  

Setting up your ESOP is just the beginning. As your company scales, managing equity compensation quickly becomes a complex strategic challenge. Scaling introduces new hires, international teams, and potential liquidity events, making manual procedures unsustainable. 

Navigating these complexities as your company grows requires a powerful platform. Pulley simplifies equity management at scale, automating cap table updates, integrating 409A valuations, and helping you design an ESOP built for scale. 

Talk to our team for a compliant, founder-friendly solution, or try a demo today.

‍