ESOPs Don’t Exist
Understand what an ESOP is so that you're equipped for investor discussions
That’s right, ESOPs don’t exist. To be more specific, at the time of negotiating an early stage investment, ESOPs usually don’t exist but if ESOPs don’t exist, what is an ESOP?
An employee share option plan (ESOP) is an employee benefit plan that gives workers an ownership interest in a company in the form of options. Start-ups use ESOPs to align the interests of their employees with those of shareholders and they are a critical tool for incentivising staff and driving high performing teams.
This description is accurate but fails to equip founders with the understanding they need to negotiate an ESOP which will invariably appear in your investors’ term sheets. This is a recurring question and I wanted to set the record as at times we can miss the point we are negotiating and it’s an important one.
When an ESOP is put on a cap. table, it is, very simply, a mechanism used to reduce your valuation in anticipation of shares you will ‘give’ to employees. [AZ1] Options issued under an ESOP are often issued at a reduced price and even when you issue options at market price, the shares they relate to may not be paid for until an exit. Given your investor is often paying a lot for their shares, they do not want to be diluted by options that you’ve given to staff which aren’t paid for. This is the reason ESOPs are shown on your cap. table at the time of an investment, even if they don’t exist yet. They reduce your valuation by the amount of the ESOP on the basis that you may then go an issue that ESOP to your employees over time.[AZ2]
Here you have 2 cap. tables showing an investment of $10 at a pre-money valuation of $90. The first has no ESOP and a share price of $1. The second has an ESOP of 10% (before the investment) and a share price of $0.90.
\As we see here, if the investor were to invest $10 in each case with and without an ESOP, they would receive 10 shares without the ESOP and 11 shares with the ESOP. That is, the valuation has been reduced by 10% - duh.
BUT this can be misleading.
Based on the above, you might assume that the dilution to the founder in the two scenarios is the difference between holding 90% of the company and 81.08% of the company. That’s a huge difference. However, the second example above only shows what the cap. table will look like in future if an ESOP of 10 shares is issued to employees, it does not show the cap. table today. If you don’t issue options to employees, the ESOP never comes into existence. It is simply a prediction of what will happen in future. This is what your cap. table looks like after the investment when the ESOP has been included to calculate the share price but no ESOP has been issued:
Put another way, after the investment the unissued portion of your ESOP and possibly the entire ESOP itself doesn’t yet exist and the fully diluted cap. table is in fact the cap. table without any unissued options shown.
The difference in dilution to the founder as between having a 10% ESOP and not at the time of the investment is actually the difference between the founder holding 90% of the company and 89.11% of the company. Once the ESOP is issued, the investor will be diluted down by the ESOP issue, eventually to 10% as intended. If employee options are never issued, the investors have received a free kick but the amount of this freebie is nowhere near as much as you might think as you must exclude the ESOP from your calculations in showing what % the investor holds without the ESOP. On the basis that no ESOP is issued (which is unlikely), the investor will hold 10.89% of the company instead of 9.91% as envisaged with an ESOP.
So what are the key takeaway and is there anything you can do to mitigate the impact of this:
The simplest way to think about an ESOP is a reduction in your valuation equivalent to the % of the ESOP itself.
The impact of an ESOP may be less significant than you might expect so make sure you understand the true impact and the fact that when you show unissued ESOP on your cap. table, it doesn’t exist (yet).
ESOPs are ubiquitous and it would be difficult to get rid of it altogether as it is standard market practice - but in general, less ESOP means a higher valuation.
The ESOP doesn’t exist at the time of the investment and if it is never issued, you don’t need to ‘unwind’ the ESOP. It’s never really created until you issue it, and you aren’t diluted by it unless you issue it.
If you don’t issue the ESOP that was accounted for in your cap. table, your investors get a limited free kick on valuation. It is possible to design mechanisms to unwind but this is complicated and unlikely to be warranted as you usually use the ESOP.
If your investor insists on an ESOP, and almost every investor will, they have reduced your valuation so that they aren’t impacted by the ESOP when it is issued. As a result you might be able to negotiate to be able to issue options to employees without investor consent. After all, it is arguable it doesn’t impact them.
You need to ensure that the issue of options doesn’t trigger pre-emptive rights. If you don’t do this, you will not be able to issue options under the ESOP without a waiver from shareholders.
If you are able to negotiate a small ESOP or no ESOP, bear in mind that if you need to issue employee options, your shareholders may push back on this on the basis that this dilution was not anticipated. This could be bad for you and your company and given your shareholders likely have pre-emptive rights, you will not be able to issue options without their consent.
That’s all for now. As always, I’d love to know what you think and always appreciate a share.
Happy investing,
Dan