ESOPs can be a case of damned if you do, damned if you don’t. Founders need an ESOP to build out and retain its team as the business grows. But dilution will often only affect the founders. That can feel like a turkey voting for Christmas. Ultimately, it is just another case of the classic founder balancing act. A smaller piece of the pie can be fine, so long as the size of the pie is getting bigger.
Dilution is the classic question that founders must grapple with when considering an ESOP, but it is not the only one. Here are my thoughts on the common questions on ESOPs I receive from founders.
1. When should I set up an ESOP?
An ESOP is usually formed at the time when the founders appreciate that they need to hire senior level employees. In the early life of a company, the company may not have the resources to pay market wages for senior people. The ESOP is used to attract senior people willing to risk lower wages for the potential upside of equity in the company on liquidity event such as a trade sale or IPO.
So, there may be no need to form an ESOP before the business has a requirement for senior talent. Typically, an ESOP is formed on a first or second investment round when investors make clear their expectation that the executive team must be more fully and properly resourced.
In more mature private companies, an ESOP may be formed when management believe that the loyalty of senior long serving employees should be recognised.
2. How big should an option pool be?
There is no hard and fast rule. In the technology sector, among fast-growing companies, it is important for the company to have a large enough option pool to attract and incentivise senior talent. However, there is a tension in that the grant of options has a dilutive effect on other shareholders. In general, market trends suggest an option pool of between 8% and 20% of total issued shares, with 10% to 12% being the norm. This varies according to the specific company, management culture, need for senior talent, and industry sector.
3. When should I grant share options to key employees?
A key employee will wish to receive share options as early as possible in the life of the company. The exercise price on share options is conventionally set by reference to the fair market value of the shares at the time of grant of the share option. The upside potential profit to the key employee is the difference between the fair market value at the time of grant, and the fair market value or actual price achieved at the time of exercise. If a share option is granted at a very early stage in the life of the company, then the fair market value of the shares will be relatively low, and this will increase the potential upside and profit to the key employee.
4. What vesting schedule should I agree?
The vesting schedule and conditions depend on the key goals the company has set to be accomplished by the ESOP. Conditions can be performance -related. Frequently though, the only condition is continued service for a period of time.
The most common vesting schedule is a four-year vesting term, with a one-year cliff. This means that the options will vest over a four-year term from the date of grant at the rate of 25% per year. In the first year, no options will vest until the first anniversary of the date of grant, when 25% of the options will immediately vest. This is the one-year cliff. The idea of the one-year cliff is that it gives both the company and the participating person a period of time to see whether they wish to commit to each other for a longer period. Thereafter, the options will vest on a periodic basis, typically monthly.
In some industry sectors, there is no principle of equal vesting over the entire vesting term. If long-term loyalty is prized, sometimes a higher percentage of options will vest in the latter part of the vesting term. For instance, the options may vest at the rate of 10% in year one, 15% in year two, 25% in year three, and 50% in the final year.
5. How does an option pool dilute my equity position?
Sophisticated investors such as venture capital funds will take the option pool into account when assessing its valuation of the company. When calculating the price per share of the company for a pre-money valuation, investors will not only include the shares presently issued, but also shares that may need to be issued to satisfy current and contemplated share option grants.
Investors will often mandate what the size of the option pool should be post-investment, and insist that the dilution caused by the option pool is taken before the investors subscribe or only dilutes the founders (not the investors). This is a negotiation point. It is not a given. Founders in a stronger negotiating position may be able to avoid this outcome. More often than not, though, the investors’ demands are met.
Then, there are two dilutive events occurring. First, there is dilution to take account of the contemplated share option grants that the VC investor is expecting the company to make post-investment. Then, there is the actual dilution caused by the VC investment itself. The sum total of this dilution is significant, and can often be a surprise to founders.
Dilution is a fact of life in the scaling of a fast-growing technology company that is taking on board external investment. The only way to mitigate extreme dilution is to seek to minimise the size of the option pool, without affecting the goals of the option pool to attract and retain senior talent.
The issue is more related to an issue of price, rather than dilution. A founder should work out three valuation prices for its business full: post-money valuation, pre-money valuation without option pool, and pre-money valuation with option pool. Once he has done so, he will have a clear understanding of how the investor is pricing the company.
6. Do I need to refresh options?
An option refresh occurs when new options are granted to a participating person who has already received an option grant previously. A vesting schedule is typically four years. If a senior employee is in the second half of that vesting schedule, he can legitimately expect to be granted new options to incentivise him for continued loyalty and performance after the vesting schedule expires. This is an option refresh.
Normally, an option refresh should be granted as soon as it makes business sense. This is because it locks in a lower fair market value for the exercise price.
7. Should an option refresh start on the date of its grant?
The choices are that an option refresh starts on the date of its grant (which would be during the currency of the vesting schedule for the prior option grant), or starts from the expiry of the current vesting schedule. The normal practice is for the vesting schedule on the option refresh to start from the date of grant. However, there is a logical argument that it is more incentivising from an employer’s perspective for the vesting schedule on the option refresh to start only on the expiry of the current vesting schedule.