The Employee Stock Option Plan (ESOP) Pool is the company’s equity for issuance to employees, directors, and, where permissible, advisors and consultants. Correctly sizing the ESOP pool is a fragile balancing act that most founders get wrong, a potentially costly error. The size of the employee option pool influences how much ownership can be retained in the company and the equity valuation and share price.
This article discusses everything from ESOP pool, cap table, ESOP pool key aspects to the effect of the ESOP pool on share price and valuation, pre-money post-money option pool & how to calculate the option pool.
ESOP pool and cap table
An ESOP pool fairly represented in the cap table pleases your investor. Investors that fund your company want to be confident that their money won’t be used for anything other than the next fundraising rounds. Let’s understand it in detail.
What is an ESOP pool?
An option pool is a portion of a company’s stock reserved for future employees. The Board of Directors and stockholders establish an option pool by authorizing a certain number of shares to be blocked for equity compensation of service providers. For eg., if you own 50,000 shares (100% of the company) & create a 2,500-share option pool, you now own 52,500 shares of the company stock on a fully diluted basis.
What are the benefits of having an ESOP pool?
One of the many effective ways to attract & retain talent is by offering equity to employees, especially if you can’t yet afford market-rate salaries. By providing employees with the opportunity to own a portion of the company, you encourage them to behave like owners & do everything they can to help the company grow & eventually play a part in its success ride.
The Prospective investors will consider whether the option pool is large enough to attract top talent and keep the business growing. After all, if they have a financial stake in your company, they will want it to succeed just as much as you do. Before speaking with investors, you can make a good impression by doing the math to determine your required pool size.
How does pre and post-money ESOP pool work?
Whether you create your option pool before/after raising funds may affect how much ownership everyone has.
Before making an investment, you create pre-money option pools. Investors frequently prefer this type of option pool because it is more investor-friendly. You only dilute your shares when you create an option pool before raising funds (and thus before issuing shares to investors).
Investors usually include an option pool in their pre-money valuation if an option pool does not already exist. Furthermore, the larger your pre-money option pool, the lower your post-money ownership percentage. If an option pool already exists, the investor may request that it be expanded if they believe there are insufficient shares to engulf hiring until the next funding round.
Why is it important to have the correct ESOP pool?
Creating an option pool is a good growth strategy, though it also dilutes stock, changes your share price, & can even change the valuation of your company. Each of these factors should be considered when determining the appropriate size. In an ideal world, your option pool should be large enough to hire enough people to elevate to the next round of funding. You’ll dilute your ownership more than necessary if you go too big. If it is too small, investors may not be interested.
- Dilute your ownership – Technically, creating ESOP pool dilutes the ownership of all existing shareholders. However, because investors frequently insist on seeing a pool before investing, the first option pool usually only dilutes the shares. The dilution can occur more quickly than you might expect. When you create an option pool prior to raising funds (and thus prior to issuing shares to investors), you only dilute your shares. Continuing with the example, if you own 50,000 shares and create a 2,500-share option pool, you can now own only 95% of the company (50,000/52,500) rather than 100%.
- Affect valuation and share price – Investors usually include an option pool in their pre-money valuation if an option pool does not already exist, as they (option pools) dilute the investment by transferring shares of the company, of which the investor owns a small percentage. Furthermore, the larger your pre-money option pool, the lower your post-money ownership percentage. If an option pool already exists, the investor may request that it be expanded if they believe there are insufficient shares to engulf hiring until the next funding round.
How does ESOP pool size differ in a cap table?
It should be noted that stock options in the ESOP pool are not considered shares until they are exercised by the employees who own them.
As a result, they appear as a line item below the total number of shares issued in the cap table and are further subdivided as allocated and unallocated. Employees who have exercised their options are included in the cap table.
Let’s look at how pool size changes as a startup progresses.
- At the early stage – Founders frequently seek funding after reaching their next milestone. As a result, planning ahead of time for your hiring needs and creating a large enough pool to distribute amongst the hires is critical. The primary goal of seed-stage startups is to develop a product and test its market viability. Because you have limited funds, you cannot afford to pay these new employees competitive wages. As a result, ESOPs are used to attract and retain talent to compensate for lower cash-based wages. Employees who join you early take a higher risk and expect to be rewarded accordingly. According to market standards, a 10-15% ESOP pool size is considered good, but keep in mind that you can keep a smaller or larger pool size depending on the hiring needs.
- Series A and B – By this stage, most startups have already developed their product and tested them with beta customers. Startups aim to acquire more customers, and the critical hiring needs are for laying the groundwork for scaling. You might want to hire growth marketers and salespeople. Because your startup is generating revenue and you may have raised a few funding rounds, you can afford to pay higher wages. Furthermore, the company is more established, and those joining are taking lower risks than those in the early stages. As a result, you can offer fewer ESOPs to new employees at this stage. At this stage, the market standard is 7-10% equity as an ESOP pool. All existing investors typically dilute their equity when creating a new pool. If the pool created previously is not exhausted/has some options left to be distributed, the founders can negotiate a low top-up to the ESOP pool for the new investors.
- Growth startups – Growth startups are those in the series C, D, and E stages. At this stage, startups have significant cash flows and a product-market fit. Startups are relatively stable, & the risk is lower than in earlier stages due to lower failure rates. According to a Trifecta Capital report, more than half of Series A startups have an ESOP pool greater than 7.5%, compared to 30% of growth-stage startups. Startups are well-known at this point. As a result, it is relatively easier to attract talent because people want to work for these startups. Because you can afford to pay competitive wages, the options should be based on performance and used to bring out the best in the employees. Startups have recently bought back ESOPs at these stages to provide liquidity to ESOP holders. This contributes to employee wealth creation, and they can reap the benefits of their contributions.
ESOP pool aspects to consider in a cap table
Two key aspects are a part of ESOP consideration in a Cap table. First is Size & the second is Timing, both of them are Interlinked. Let’s understand both aspects in depth.
- Pool size – Benchmarks from other companies can be useful in ensuring your option pool size is pretty close, but they can also be dangerous to rely on. There’s a reason why the typical percentage founders set aside varies so much, and each company is unique.
- Large pool size – Enough to potentially create sufficient wealth for employees
- Small pool size – Enough to ensure shareholder dilution is within limits
- Pool Time – We always recommend that organizations abandon the templated approach and do their own math to determine the size and timing of their ESOP pool based on their immediate and future needs.
- Immediate – Enough to meet the needs of current employees as well as short-term hiring plans
- Deferred – long enough to limit dilution of existing shareholders while still leaving enough for future grants
Why should companies dilute slowly to protect founders?
Many organizations take an abstract approach and use a benchmark or rounded number to determine the size of the ESOP pool. What complicates matters is that such a pool is formed immediately rather than gradually, resulting in more than necessary dilution and harming the interests of initial/founding shareholders/promoters.
Manage your ESOP pool or cap table with Eqvista!
Managing ESOPs can be a complicated task, let alone managing your ESOP pool size. If you need help in managing your ESOP pool or cap table, Eqvista is your best choice. With our easy-to-use cap table management solution with guaranteed protection and confidentiality, Eqvista is with you every step of the way in managing your company equity better. To learn more about our cap table management platform, feel free to contact us today!