Kevin Jun Lin, Corporate Lawyer

Case: In 2024, the founder of a Series A SaaS company valued at RMB 500 million hesitated at the negotiating table — the investors demanded the team ESOP not exceed 8% of total equity, while the CTO insisted on reserving 12%. “Programmers aren’t worth that much; 6% is enough,” the investor said, throwing up his hands. Yet during the three months the negotiation stalled, three of the company’s core architects were poached by a competitor offering double the equity incentive; the product iteration cadence slipped from biweekly to monthly releases, and customer churn surged by 12 percentage points. Ultimately the founder made the hard decision to raise the ESOP to 10% and designed a “technology milestone accelerated vesting” mechanism. A year later, the core team had zero attrition, and the product iteration cycle was compressed back to 10 days.

This case reveals a harsh reality: in the software industry, people are not merely resources — they are the assets themselves. And the ESOP (Employee Stock Ownership Plan) is the industry’s most fundamental tool for pricing and retaining talent.

I. Why Does the Software Industry Need a Higher ESOP Ratio?

1.1 The Fundamental Difference in Asset Structure

For traditional manufacturing enterprises, the core assets are plants, equipment, and production lines — tangible and precisely measurable on the balance sheet. A manufacturing company valued at RMB 1 billion may have RMB 600 million in fixed assets, and a 3%–5% employee stake is sufficient to cover incentives for the core management.

The balance sheet of a software company is entirely different. A SaaS company valued at RMB 1 billion may have less than RMB 5 million in fixed assets — a few servers and some office equipment. What are the remaining RMB 995 million? They are code, product architecture, algorithm models, and the collective wisdom and continuous delivery capability of the development team. These assets do not appear on the balance sheet, yet they constitute almost the entirety of the enterprise’s value.

Statutory reading: Pursuant to Article 48 of the newly revised Company Law, effective July 1, 2024, shareholders may contribute capital in cash, or in kind, intellectual property, land-use rights, equity, creditor’s rights, and other non-monetary property that can be monetarily valued and lawfully transferred. A software company’s core assets — source code, technical architecture, and algorithms — fall within the scope of intellectual property, whose valuation is inherently highly uncertain, and that uncertainty stems precisely from the technical talent that creates these assets.

1.2 Human-Capital Intensity Determines the Incentive Ratio

Research data shows that ESOP pools in the technology sector typically range between 10% and 20%, with the software industry advised to stay at no less than 10%. This figure is far higher than the 3%–5% in manufacturing and 5%–8% in consumer sectors. The reason is simple:

• Extremely high cost of talent replacement: The combined cost of recruiting, training, and productivity recovery for a senior software engineer with five years of experience leaving is about 150%–200% of their annual salary. For a core architect, this ratio may reach as high as 300%.
• Continuous delivery depends on team stability: Every iteration of a software product builds on an understanding of the existing code base, and a newcomer typically needs 3–6 months to become familiar with a giant code base.
• Tacit knowledge is non-transferable: Code comments will not tell you “why this architectural decision was chosen in the first place”; such tacit knowledge exists only in the minds of the core developers.
  

II. Technology-Milestone Incentives: The “Time Lever” of ESOP

Traditional ESOPs typically adopt a “time-based vesting” model — 25% vests after one year of service, and 100% after four years. This one-size-fits-all model has a fatal flaw in the software industry: it rewards “putting in time,” not “creating value.”

2.1 The Design Logic of Milestone-Accelerated Vesting

A technology-milestone incentive is a mechanism that ties equity vesting to technical outcomes. Typical designs include:

• Product-launch milestone: A core version (V1.0/V2.0) successfully launches and passes baseline performance tests, with an additional 5%–10% of options vesting.
• Technical-metric milestone: The system’s concurrent processing capacity reaches the agreed metric, the algorithm accuracy exceeds the agreed threshold, etc.
• Commercialization milestone: Paid customers exceed 100, ARR reaches RMB 30 million, and other commercial metrics directly tied to technology deployment.
• Patent/open-source milestone: Obtaining a core technology patent grant or an open-source project’s Star count exceeding the agreed number.
  

2.2 Practical Points: The “Verifiability” of Milestones

When designing technology-milestone accelerated-vesting clauses, the greatest legal risk is disputes caused by excessive room for subjective judgment. A phrasing such as “product stability reaches industry-leading level” is almost impossible to prove in a dispute. In practice, we recommend:

• Objectification: Convert milestones into quantifiable, traceable metrics. For example, “the system’s P99 latency shall not exceed 200ms at peak concurrency of 10,000 QPS,” rather than “the system performs well.”
• Third-party verification: Provide that an independent third-party technical assessment institution shall issue a verification report.
• Phased release: The additional equity from a technology milestone is not released all at once, but vests evenly over 12–24 months after the milestone is met, to prevent immediate departure upon achievement.
  

Practical point: Technology-milestone incentive clauses must be coordinated with the equity-incentive provisions of Articles 162 and 163 of the newly revised Company Law. Listed companies may adopt restricted stock, stock options, and the like; for non-listed companies implementing an ESOP through a limited-partnership platform, the partnership agreement must specify the milestone-achievement conditions and the vesting calculation method, and be signed and confirmed by all partners.

III. Full Coverage vs. Core Coverage: A Tiered Incentive Strategy for Software Companies

A classic question that troubles software-company founders is: to what level should the ESOP extend? Full coverage where “everyone gets a share,” or core coverage where “only the key few” are included?

3.1 Analysis of the Pros and Cons of the Two Models

3.2 Hybrid Incentive Model — Best Practice

Synthesizing industry best practices, we recommend that software companies adopt a “core pool + universal pool” hybrid model:

• Core pool (70% of the ESOP): Allocated to key positions such as co-founders, technical VPs, chief architects, and core product managers — about 5–15 people — using dual time-plus-milestone vesting.
• Universal pool (30% of the ESOP): Covers all regular employees with a small per-person share, mainly to foster a “co-entrepreneurship” culture.
• New-grant mechanism: Reserve 10% of the ESOP as a flexible pool for onboarding incentives for key new hires and annual outstanding-contribution awards.
  

3.3 Notes from the Perspective of the Labor Contract Law

Statutory reading: Pursuant to Article 17 of the Labor Contract Law, the mandatory clauses of a labor contract include labor remuneration. Equity incentive, in legal nature, is a conditional deferred-compensation arrangement and is not part of wages. In practice, we recommend explicitly providing in the labor contract that “the equity incentive plan shall be governed by a separate Option Grant Agreement signed between the company and the employee, and its exercise conditions, vesting arrangements, and repurchase mechanism are independent of the employment relationship.” This provision can effectively prevent an employee from claiming, upon dismissal, that “unvested options should be converted into cash compensation on a pro-rata basis.”

IV. Differentiated Departure-Repurchase Pricing — The Most Litigation-Prone Aspect of ESOP

How to handle an employee’s ESOP shares upon departure is the “number-one high-incidence area” of equity-incentive disputes in software companies. In practice, litigation arising from unclear departure-repurchase pricing accounts for over 60% of ESOP-related disputes.

4.1 Why a Differentiated Repurchase Mechanism Is Necessary

The biggest problem with a uniform repurchase price is “the good suffer and the bad profit.” A technical backbone who worked at the company for six years and participated throughout in building the core product from zero to one, leaving normally for family reasons, and an employee hired three months ago proven to be a poor fit, if subject to the same repurchase price, is neither fair nor consistent with the original intent of the incentive.

4.2 Four Dimensions of Differentiated Repurchase

4.3 Key Clause-Drafting Recommendations

In the Option Grant Agreement, we recommend clarifying the following three issues:

1. Identification of the repurchase obligor: Provide that the repurchase obligation is borne by the founding shareholders or the holding platform, rather than by the company directly repurchasing. Under the framework of the newly revised Company Law, a limited liability company’s repurchase of its own equity is subject to strict statutory conditions, so repurchase by a founding shareholder or limited-partnership platform is easier to operate.
2. Formula for the repurchase price: Avoid vague concepts such as “fair value”; instead use a clear formula — for example, “most recent post-money valuation × shareholding ratio × discount coefficient” — and specify how the valuation is evidenced.
3. Payment arrangement for the repurchase price: Given that software companies typically face tight cash flow, installment payments may be agreed (e.g., four installments over 12–24 months), with a penalty clause for delayed payment.
   

V. Risk Warnings

1. Legal consequences of an insufficient ESOP ratio: Although the law does not mandate a minimum ESOP ratio, too low a ratio may lead to the loss of core talent, indirectly triggering non-compete disputes and the risk of trade-secret leakage.
2. Tax-compliance risk: The deferred-tax preferential treatment for equity-incentive personal income tax, provided by the Ministry of Finance and the State Taxation Administration in 2024, has strict applicable conditions; if a non-listed company’s ESOP fails to meet the filing requirements, employees may face immediate personal income tax upon exercise.
3. Nominee-shareholding risk: Implementing an ESOP through founder nominee shareholding still carries, under the newly revised Company Law, the legal risk of being characterized as nominee shareholding rather than genuine incentive; a limited partnership is preferred as the holding platform.
4. Disclosure obligation: A company intending to list must fully disclose in its prospectus the grant, exercise, and repurchase of its ESOP; a poorly designed ESOP may become a listing obstacle.
   

VI. Action Recommendations

1. Assess the ESOP pool size immediately: Against the company’s valuation, team size, and financing stage, confirm whether the ESOP ratio is at least 10%. If below 8%, negotiate with investors promptly to enlarge the ESOP pool.
2. Introduce technology-milestone accelerated vesting: Add 2–3 quantifiable technology milestones to the existing ESOP plan as triggers for additional equity vesting.
3. Review departure-repurchase clauses: Examine the repurchase clauses in existing Option Grant Agreements one by one, ensuring the repurchase price is differentiated by reason for departure and the calculation formula is clear and unambiguous.
4. Build a compliant holding platform: If a limited-partnership holding platform has not yet been established, complete the structure promptly to avoid nominee-shareholding risk.
5. Complete tax filing: Eligible enterprises should promptly file an equity-incentive deferred-tax registration with the competent tax authority to secure tax benefits for employees.
   

This article is written by Lawyer Kevin Jun Lin and is provided for legal-exchange reference only; it does not constitute formal legal advice.

For professional legal advice tailored to your specific circumstances, please contact the Lawyer Kevin Jun Lin team.

💬 Welcome to leave your views and reasons in the comments section

Further Reading

• Source Code Escrow: What If Investors Fear Being Held Hostage When the Founder Controls All the Code?
• IP Contribution in the Software Industry: A Founder Contributes Code at a 10 Million Valuation? Investors Go Silent After Due Diligence
• When a Founder Suddenly Dies, Who Gets the Equity? Without This Clause in the Charter, Everything Changes
• Non-Compete Clauses: What Can You Do When a Partner Starts a Rival Business?
• Profit Distribution: How to Divide Profits? No Agreement Means Disaster
• Equity Vesting: What Happens to Equity When a Founder Leaves Early?

If you need professional support in shareholders’ agreement review, investment term-sheet review, or shareholder disputes, please contact Lawyer Kevin Jun Lin (Shenzhen corporate lawyer) for a one-on-one consultation.