How to determine the ESOP pool size with a cap table?
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.
Example of how an ESOP pool typically works
Below we added an example of how ESOP works in a tech company, Zen Tech is a growing tech company that has decided to create an ESOP pool and grant stock options – ISO to its employees as part of a new incentive compensation plan.
| Total Company Shares | 1,000,000 |
| Percentage Reserved for Option Pool | 10% |
| Number of Shares (Reserved for Option Pool) | 100,000 |
- The board of directors approves the creation of an ESOP pool. They decide to allocate 10% of the company’s total shares to the ESOP pool.
- The vesting period would be 4 years, with a 1-year cliff. This means an employee must stay for at least 1 year to start earning shares, and then vest over the next 3 years.
- The employees can exercise their options at the strike price and sell them, subject to company policies and market conditions.
Tax Implications:
- When the ISOs are exercised, the difference between the market price and the exercise price (spread) may be subject to the Alternate Minimum Tax (AMT).
- If the options are held for at least two years from the grant date and one year from the exercise date, the profits from the sale will be taxed at the long-term capital gains rate. Otherwise, they will be taxed as ordinary income.
An employee is granted 15,000 stock options (ISO) with a strike price of $0.75 per share. After four years, they sold vested shares at $4 per share.
| Strike Price | $0.75 |
| Sale Price | $4 |
| Total Taxable Income | $48,750 |
| Capital Gains Tax (15%) | $7,313 |
- The difference between the strike price ($0.75) and the sales price ($4), is $3.25 per share for the 15,000 options received. This would give the total amount of $48,750, even if the employee has exercised the options.
- In this case, the profits from the sale will be taxed at the long-term capital gains rate i.e.15% (as per US long-term capital gains rate) since the options were held for at least two years from the grant date and more than a year from the exercise date. The capital gains tax will be $7,313.
With the help of an ESOP pool, companies can effectively reward their employees, foster loyalty, and drive the company’s growth through increased employee engagement and productivity.
What are the benefits of having an ESOP pool?
Implementing an ESOP pool can benefit the organization, all involved parties, and its employees, fostering a culture of shared success and long-term growth. Employee Stock Ownership Plan (ESOP) pools offer several key benefits for both companies and employees:
| ESOP Benefits for Companies | ESOP Benefits for Employees |
|---|---|
| Attracting and retaining talent ESOPs help companies attract and retain top talents by offering employees a stake in the company's success. | Financial stake in the company Employees gain an ownership interest in the company, potentially increasing their overall compensation. |
| Improved corporate culture ESOPs foster a sense of ownership among employees, leading to a stronger corporate culture and alignment of interests between employees and shareholders. | Sense of ownership ESOPs can make employees feel more valued and appreciated, which can lead to greater job satisfaction. |
| Increased employee motivation When employees have ownership in the company, they are more motivated to contribute to its growth and success. | Long-term financial planning ESOPs can provide employees with long-term financial planning and retirement savings. |
| Tax advantages ESOPs offer various tax benefits for the sponsoring company. | Tax advantages Employees may benefit from certain tax advantages associated with ESOPs. |
| Succession planning tool ESOPs can be used as an effective strategy for succession planning, especially in closely held companies. | Potential for wealth creation As the company grows and succeeds, employees have the opportunity to benefit financially from the increase in share value |
| Cost-effective compensation ESOPs allow companies to offer competitive compensation packages without significant upfront cash outlays. |
When implemented correctly, an Employee Stock Ownership Plan (ESOP) can be valuable in a company’s corporate finance strategy. It helps to align employee incentives, company growth, and shareholder interests.
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 an 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.
Factors Affecting Pool Size
When determining the ESOP pool size, it’s crucial to maintain a balance to the need to attract and retaining talent with the goal of efficient cap table management. Rather than relying solely on industry benchmarks, companies should use a bottom-up approach that considers their specific hiring plans, business projections, and long-term objectives.
The size of an ESOP pool is influenced by several key factors:
| Factors | Description |
|---|---|
| Cash flow | A company's financial resources and ability to sustain an ESOP are crucial. A feasibility study can help determine the company's capacity to pay ESOP loan debt and handle repurchase obligations. |
| Company valuation | The pool size is inversely proportional to the company's valuation. As the company's value increases, the relative size of the pool may decrease, though the absolute value of shares may increase. |
| Hiring requirements | The pool size should accommodate current and future hiring needs, especially for critical positions and C-suite-level executives. |
| Company size and stage | Generally, ESOPs work best for companies with at least 20 employees. The pool size typically ranges from 10% to 15%, but this can differ based on the company's stage and needs. |
| Funding stage | Pool size often changes as a startup progresses through different funding rounds. For example, more than half of Series A startups have an ESOP pool greater than 7.5%, compared to 30% of growth-stage startups. |
| Dilution considerations | Creating an ESOP pool dilutes existing shareholders' equity. The size should be large enough to attract talent but not so large as to overly dilute ownership. |
| Employee preferences | Some employees may prefer larger stock options with a salary cut, while others may want ESOPs in addition to their regular salary. |
| Future funding plans | When setting the initial pool size, it's important to consider potential future funding rounds and investor expectations. |
| Company growth projections | The pool size should align with the company's long-term growth plans and projected valuation increases. |
| Timing of dilution | The impact of dilution changes over time with each funding round. While the percentage of the ESOP pool may decrease, the underlying value often increases as the company grows. |
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.
Benefits of Using Cap Table Software for ESOP Management
Cap table management software offers several key benefits for managing Employee Stock Ownership Plans (ESOPs) compared to manual methods:
| Benefits | Description |
|---|---|
| Streamlined Administration | |
| Improved Accuracy and Compliance | |
| Enhanced Transparency | |
| Simplified Reporting and Analytics | |
| Centralized Document Management |
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.
How to Create an ESOP Pool with Eqvista?
If you are using Eqvista, you can issue shareholders with options instead of company shares. Options are usually given to employees and shareholders of the company. The holder of the option can exercise and sell the company’s shares.
Steps to create an option pool on Eqvista
Step1: Log into your Eqvista account and choose the company account.
On the dashboard, click on “Securities” on the left side to get a drop-down menu and select “Options”.
Step 2: On this page, if you have created some, you will see them there. Here, you will see the option to create a new option pool and click on “Create New Class”.
Step 3: Then, you will be directed to the page to set up the option pool by giving it a name and reserving shares.
Once you have filled in the details, select “Submit”.
Step 4: With this, the option pool has been created and you can now begin the process of issuing options.
Select the options class name, a button shows up below it that says, “Add new grant”.
In this way, you can create an ESOP pool in Eqvista and issue options to employees and shareholders.
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!
