All you need to know about Employee Stock Option Pool (ESOP) Part #1
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Everybody knows the feeling, you are talking to a friend and you think you both are talking about the same topic, but somehow, you talk past each other because you get lost in translation at some point, which happens. Well, the occasional same occurs when talking about ESOPs with founders, employers, employees, or even investors.
Even though ESOP is an important component of every funding round and there is surely an infobesity on the mechanics and components of ESOPs on the read-write web, some parties are still not confident enough about the mechanics and the impact as you can see below...
Therefore, this piece will try to capture the essence of all the important components when it comes to understanding ESOP to its fullest…because it might be easy to think that equity is mechanical and dry, but it is important to understand its granularity. Everybody should put in the effort to learn how various stock options with attached scenarios work and their implications on the employees.
🤨 What is an Employee Stock Option Pool?
An Employee Stock Option Pool (ESOP) — is the legal framework for giving stock options to employees. Meaning, that it is equity specifically allocated for employees, with standard terms and provisions attached - for a better understanding of standard terms and provisions you should check the YC stock plan form.
In a perfect world, founders create an ESOP when the company is ready to hire or usually throughout the pre-seed / seed financing round when the lead investor is requesting it. The ESOP helps you among others hire top talent, as we all know that talent is a key bottleneck for early-stage companies. However, considering, that the option pool represents a portion of ownership in the company, its creation impacts the ownership of founders, existing and in some cases new investors in form of dilution, but more on that later.
🧐 Why is an ESOP important?
As already indicated above, equity is the “MVA” - the most valuable asset of every founding team, and any resulting dilution is an important negotiation point, as founders should be unwilling to give up equity lightly.
However, building a unicorn usually comes with a stellar team, and as every ambitious founder knows, stellar talent is scarce and the key bottleneck, considering the competition through high rewarding compensation packages (from large corporates) or scale-ups - the startups need to enter the “Talent War” (btw my dear friend Nikita, from Hummingbird wrote an interesting piece on that). Therefore, as a startup, you need to leverage any equity in the best possible way when it comes to human capital. And founders certainly do have leverage - Next to a compelling fast-paced working environment and vision, founders can offer a larger benefit in form of ownership - through stock options.
Giving your team the opportunity for ownership, that could become exponentially valuable after a couple of years, and to participate in the financial upside that could result, is a compelling proposition. With less cash at your disposal for salaries, especially in the early days, stock options are also given to employees in place of the cash compensation and benefits that they might receive at larger companies. This enables founders to create an attractive compensation package to compete for the best talent out there.
For the sake of visualization, below you can see the value of stock options of leading tech companies at the time of their IPO, underlining the importance of an ESOP and its value creation for its employees:
But is the monetary incentive the only benefit of a stock option? The plain answer is no, in fact, stock options can result in various benefits for founders:
Motivation - Having a personal stake in the success of the company motivates them to be fully productive and build sustainable value because they own a stake in the company and have a vested interest in the long-term success.
Control cash burn - Giving employees stock options may be costly from an equity perspective—but the startup does not need to pay cash effectively. Stock options allow startups to grow and attract talent while keeping a lid on their cash outflows.
Retention - Stock options have a vesting schedule across multiple years, in line with your valuation, and create disincentives for leaving. This gives your employees ongoing reasons to stick with you.
Rewarding - Stock options can have similar characteristics as cash bonus payments at the end of the year, by providing top talents with a top-up to their existing stock options as a bonus for the past year’s performance. This strengthens the previous retention point additionally.
Tax advantages - Issuing options, rather than shares or cash compensation has the benefit of potentially being more favorable from a tax perspective.
🤌🏼 The ideal size of ESOP
Naturally, after understanding the foundation, the logical next question founders tend to ask is:
How much equity should founders put aside for their employees?
If you screen the ocean of investor recommendations, you will not land on “the perfect answer” but the golden rule of thumb is an ESOP of 10% at the Seed stage. This number is generally seen as “standard” across Europe at least.
In the perfect world, the ESOP allocation should be based on your hiring plan throughout the next fundraising window, with the caveat of future uncertainty. Expect investors to ask the ESOP to be sized at a round figure.
However, as always, there are also other factors contributing to the “right” size of the ESOP, besides the aforementioned hiring plan:
Composition of the founding team - Solo founders naturally need to plan with a larger pool given the need for multiple key hires down the road compared to a 2 to 3 people founding team. Additionally, the current state of the current product development should be taken into account, especially if you outsource early developments and use an “off-the-shelf” solution for your first lean MVP.
Technical Co-Founder - If you are lacking a technical co-founder and you aim to hire a non-founding CTO, you should earmark a larger portion as well.
Focus area - State-of-the-art technology challenges (i.e. Deeptech) require a large and exceptional technical team, therefore you should also focus on creating a larger ESOP from the get-go.
Hiring Competition - Depending on the talent you are going for, you need to be aware of the companies around you striving around the same pool of talents. Depending on their pocket size, hire potentially expect high offers of equity participation, which in turn forces you to need a larger than average ESOP.
Considering its importance, founders should align with investors and the board on the right ESOP sizing, and if needed reviewed each year, especially if hiring plans are set to change on a larger scale.
💥 Dilution Impact
“Downside” for every founder when creating an ESOP is the resulting dilution, considering a certain percentage of the equity will be earmarked for employees - which results in a pro-rata reduction of ownership for existing equity holders, given the equity is 100% allocated at this point in time.
Calculation of the dilution impact can either be done by considering the pre-money valuation, or post-money valuation.
ESOP based on Pre-Money Valuation
“A pre-money valuation is the value of a company before a new outside investment. Pre-money valuations generally form the basis of what a VC’s share in the company is determined to be worth, based on how much they invest.” - by Angellist
Let’s put some numbers to it, to visualize the difference between both valuation exercises and the implied impact.
We assume Miyagi (Startup Name) has 1,000,000 outstanding shares and no established ESOP before the planned Seed round. Now, Miyagi plans to raise €2m on a pre-money valuation of €10m (implies a post-money valuation of €12m). This aimed funding round and proposed valuation would lead to an implied price of €10 per share.
Assuming the new investor requires the creation of a new ESOP pool equal to 10% of the post-money valuation - meaning the ESOP needs to be included in the pre-money valuation. This mechanic translates to a €1.2m ESOP (10% of the €12m post-money valuation).
This will have an impact on the implied share price as well as the pre-money valuation:
Pre-Money Valuation: The real pre-money valuation is €8.8m and not the aforementioned €10m.
Implied Share Price: This implies also a new per-share valuation of €8.8 (€8.8m divided by 1,000,000 outstanding shares), considering new shares will have to be created for the option pool.
Bottom line, creating an ESOP based on the pre-money valuation leads to a dilution of all existing equity holders, whereof the new investor avoids any dilution. In Europe, carving out an ESOP based on its pre-money valuation can be considered as a market standard.
ESOP based on Post-Money Valuation
“A post-money valuation is a company’s estimated value after receiving outside investment or financing. So if a company was worth $10M, and then it raised another $5M, its post-money valuation would now be $15M.” - by Angellist
Implications of carving out an ESOP based on pre-money valuation were laid out before, but how do the numbers turn out if it is based on the post-money valuation instead?
We assume the same pre-money valuation of €10m, with a €12m post-money valuation - Miyagi’s founder will hold a ~83% and the investors ~16% before the creation of the ESOP.
This time, the 10% option pool is carved out from the post-money valuation, meaning everybody gets diluted by 10%. Post-option pool creation, the founders will hold ~75%, the investors ~15%, and the option pool 10%. The option pool dilution is equally distributed.
Evidentially, the ESOP creation based on the post-money valuation is much more founder friendly. However, the industry norm is for ESOPs to be carved out from the pre-money valuation.
To conclude Part 1 (of 2) of ESOPs, find attached a cheat sheet with all the key considerations from this post today.
⭐️ Cheat Sheet #1
As indicated above, that is Part#1 with Part#2 coming next Monday. The forthcoming piece will go deeper into the mechanics and will deep dive into topics such as strike price, strike price determination based on 409A, option shuffle, top up, and resulting ESOP evolution as well as a ready-to-use calculator!
See you next Monday 🦄
PS: Feel free to share this post with whomever you think is helpful!
- KD