Demystifying Employee Stock Options

I came across a lot of questions recently about how ESOPs and salaries should be managed at an early stage. In this post, I’m putting together what I have learned so far — starting with basics on how ESOPs work and why they are important, followed by a few guidelines on how ESOPs should be managed and how allocation needs to be thought of. Lastly, I have taken the liberty to point out a few fallacies/traps that first-time entrepreneurs might fall into when allocating ESOPs to new hires. Hope you find it useful…

Note: This post is particularly relevant for Indian founders at funded startups at Seed and early Series A stage.

How ESOPs and the ESOP Pool work — the basics

Carving an ESOP pool requires that all current shareholders dilute certain % of their ownership to allocate to the ESOP Pool. So, if it’s the first time the ESOP Pool is being created, the founders dilute a portion of their equity to create the ESOP pool and every time the ESOP Pool is replenished, it requires further dilution. So essentially, founders and investors part with some of their ownership in the company each time the ESOP pool is replenished. You will replenish the pool if it is insufficient for the company’s hiring needs.

With every subsequent round, the ESOP Pool like all other stock gets diluted. So, if you allocate 10% of the stock options to the pool at seed, this pool will dilute to 8% when you raise another round at 20% dilution. Similar logic applies to ESOP grants. If you give 1% in ESOP to an employee at Seed stage and the company dilutes 20% at series A, this 1% ESOP dilutes to 0.8% and further dilutes to 0.64% if you raise another round at additional 20% dilution. Of course, despite the dilution, since the valuation of the company is likely to go up with every round the options are worth a lot more with every subsequent round, even though the percentage ownership drops.

Note also that the payout from the options assigned from the pool is a function of the strike price at which the option is offered. If someone owns 1% of the company in stock options, it doesn’t automatically mean they get 1% of the exit value. The strike price matters. If the ESOP was offered at a strike price of $2, the dollar ownership of the employee at the time of exit, if he exercises his options, will be

Number of shares allotted X (Current price per share — $2)

Typically strike price is set at the time that the ESOP is offered to a hire and is generally based on the last known valuation of the company. This makes ESOPs that are acquired at an early stage a lot more attractive. The strike price is lower at this point and as such, multiples at the time of exit are higher!

Purpose of the ESOP Pool

ESOPs essentially serve three main purposes:

1. Complete an “incomplete” team: If you are a sole founder and need to make senior hires that are just as committed to the success of the company (almost like co-founders), you may want to part with some equity to include them in your vision. A lot of times, these folks are hired early in the life of a startup and they take huge salary cuts for a substantial ownership in the company. Typically, investors will insist on a larger ESOP Pool if such hires need to be made.

2. Fill Gaps in the org: ESOPs give you the option to hire talent that you wouldn’t otherwise be able to afford. For instance, if you are a team of technical founders, then hiring a business person or a functional expert can be very useful. However, this person will probably be compensated very well in the market. As such, you may not be able to pay him a market salary. In this scenario, it makes sense to compensate this person with ESOPs to make up for the loss in salary.

3. Incentivize Performance and retain high performers: ESOPs give you a way to recognize, incentivize and encourage talent in your company. Giving ESOPs to employees that are outperforming lets them know that you value them tremendously and helps with retention as well.

How should you allocate ESOPs?

ESOPs are really the lifeline for a startup. At pre-funding stages, it is useful for hiring the first few team members when you have practically no cash to give out. At early stages, you have less cash but still need to grow your team. At later stages, new challenges arise (increased competition requiring you to scale rapidly, perhaps a business pivot requiring rapid re-hiring, additions/changes in the management etc.) where again you might need ESOPs to come to the rescue. The pool, however, is limited. On average, most startups end up allocating 10% — 25% to the ESOP Pool over the lifetime of a company. This is typically a function of how much you raise, what valuations you hit and how large a team you need to build.

If you give away too much equity too early, you will have to replenish the pool and dilute often. If you give away too little, you might not be able to onboard folks that can seriously move the needle for your organization. This makes it important to put some thought into how much equity you allocate to the pool and how you plan on utilizing it.

How much ESOP gets allocated to an employee should ideally be a function of three things:

- The number of hires you need to make and the ESOP Pool available to you

- The value that the person adds to your company. For instance, senior hires and domain experts typically end up getting more ESOP than junior hires

- Salary compensation of the hire. Typically if a hire is expected to take a larger pay cut, you might want to compensate her with more stock. This is also why first few employees in a startup end up getting more %ownership than later hires

Note also that ESOP allocation can differ basis several other factors as well. For instance,

- Average ESOP allocation for a role may be different in different countries. Might even differ by city (in more competitive cities, one might have to part with more stock)

- Allocation can be higher if a particular skill is just hard to find

The sheet here provides a basic framework for thinking about ESOP pool allocation along with market comps for certain roles (specific to tech startups in India). Take the numbers with a pinch of salt and use it as just another data point. The values may be different for you depending on how critical a role and a person is for you and what stage your startup is at.

Guidelines

Give ESOPs to as many employees as possible:

- As a general rule of thumb I prefer following this strategy. Try to give ESOPs to as many employees as possible. This gets difficult at later stages when junior hires don’t end up getting ownership. But at an early stage, I’d encourage allocating options to as many hires as possible. People are taking a bet on your company when they can just as easily join a large brand name company and load up their resumes. They are choosing to trust you and this needs to be acknowledged.

Discuss ESOPs at the time of joining; don’t leave it for later:

- Be upfront about how much ESOP an employee will get and at what strike price. Negotiate the same before the person joins and not after (even if you aren’t funded yet). Take the time to have your ESOP policy and grant structure ready sooner than later. Leaving this discussion for later, simply leaves employees in a confused state and leads to resentment.

ESOP Vesting:

- I have found a four year vesting schedule, with a one year cliff followed by quarterly (in some cases monthly) vesting to be the norm. In this scenario 25% of the allocated ESOPs vest every year.

- Sometimes, companies adopt a 10–20–30–40 vesting schedule. I feel this model impacts employee retention and satisfaction. But a case can be made in favor of such a vesting schedule as well.

Transparency:

- Put systems and/or software in place for employees to track their ownership. Do this sooner than later. No one likes to be kept in the dark. Provide access to the system to both your current and ex-employees. I am often surprised at how guarded founders are about the company’s valuation and/or stock value with their own employees. What’s the point of allocating ownership, if one can’t associate a number with it? And why would anybody value such options?

- Put a system in place to let employees know if there is an opportunity for liquidation. I personally believe it’s unfair if only a handful of employees that are “close to the CEO” are told about liquidation opportunities. Some startups like Flipkart and PayTM have done this well — I’m sure the employees there truly appreciate the system and the founders for putting it in place.

Fallacies!

1. If the team is small, everyone deserves the same equity:

In a small team, founders are concerned that it will be difficult to hide salaries and equity. As such, differential treatment may lead to resentment. This isn’t a reason to match salaries or equity. Consider this — if you were working for someone else, wouldn’t you like to be rewarded more if you were performing better than your peers? The rule applies at all stages of the company — 4 employees or 4000. Culture setting begins the day you onboard your first team member. If you want to create a culture of rewarding performance, start from day One!

2. Person X deserves more ESOP because he is extremely loyal and has tremendous faith in the idea!

Giving more ESOP to an employee because he is loyal, has more faith in the founder or the startup is another bad reason for giving away stock. Having faith in the founder and the idea are table stakes for working at a startup! ESOP and salary compensations should only be a function of the individual’s impact potential on the company’s success and direction.

3. We have just started out. It is hard for us to attract talent. So we must give more ESOP to hire people.

This is true to some extent. But it also does not mean that you give away more than the market standard. A founder CEO is nothing if not a great salesman. It’s time to upskill. You have to find a way to be a talent magnet. In fact, most investors spend a lot of time gauging if the founder is capable of hiring extraordinary, more senior and capable talent. You simply have to learn to be better at this.

4. This guy has the potential to become a valuable employee in the future, hence I am giving him more equity today.

You don’t really know this. Startup journeys are generally very difficult. Many stars fall through the turmoil of a startup journey. Evaluate the person for what he brings to the table today. Then, over time, if he performs and scales rapidly, by all means, reward him with more equity.

Well, that’s my two cents on ESOP planning. Would encourage entrepreneurs to chime in with ideas/thoughts in the comments section — share your personal experiences. Will help the community…

PS: A big shout out to Anshoo Sharma, Venture Partner @ LSIP, currently Co-Founder & CEO @Magicpin and Maninder Gulati, ex Principal @ LSIP, currently the Chief Strategy Officer @ Oyo for their inputs…