ESOP: The burden with “burden bearing”

It’s common in early-stage (seed) funding rounds that a certain percentage of the post-financing capitalisation is reserved for employees. This does not necessarily require a ready-to-go incentive plan (often also referred to as “ESOP” = Employee Share Option Plan) when the round is signed. It just means that founders and investors agree that a certain amount of equity (mostly in the form of options or virtual shares, which we’ll collectively refer to as “options”) is reserved for existing employees and to facilitate hiring. Normally this is based on the understanding that the pool is to be allocated (mostly) before the next financing round.

Because investors don’t want to be diluted right away by near-term option allocations that are essential for the successful development of the start-up, it’s common that the option pool is included in the funding round valuation. This can be done in two different ways, which — even though mathematically similar — can make a significant difference in practice:

Option 1:

The incentive pool is added “on top” of the existing (nominal) share capital. This leads to an immediate dilution of the existing shareholders (founders) and lowers the price that the investors pay for their shares. Here is an example: Let’s say the founders hold 700,000 shares pre-funding and there is to be an option pool of 10% after the funding round (“post-money”). The investors agree to invest EUR 2 million at a pre-money valuation (including ESOP) of EUR 8 million, i.e., they are to get a 20% stake. The fully diluted cap table after the funding round will therefore comprise 1 million shares and share equivalents, of which the founders hold 70% (700k shares), the investors 20% (200k shares) and 10% is allocated to the ESOP (100k shares or share equivalents). The price per share will be EUR 8 million divided by 800,000 (fully-diluted) shares pre funding, so EUR 10.

Option 2:

The founders allocate a certain portion of their shares to the ESOP, which, simply spoken, means that in case of a sale the proceeds on these shares are to be used to fulfil the ESOP claims of the employees. The shareholders’ agreement would for instance state “the common shares XYZ bear the burden of the ESOP”. Using the example above as a starting point, the numbers would look as follows: Because the ESOP is “included” in the 700k founder shares, the price per share is EUR 8 million divided by 700k shares = EUR 11,43 (rather than EUR 10) and the investors will “only” receive EUR 2 million / EUR 11.43 = 175k shares (rather than 200k shares). Post funding the founders will hold 700k / 875k shares = 80% (rather than 70%), BUT 87,500 of those shares are allocated to (“bear the burden of”) the ESOP, so economically the founders’ stake is only 70% (= (700k — 87.5k)/ 875k), which is the same as in the first example.

You may think, what’s the big deal, both results came out the same. This is indeed correct IF the ESOP is fully allocated and vested at the time of an exit, which, however, does not have to be the case. Let’s assume in the example above the company is sold and only half of the options have to be paid out (because the other half has not yet been allocated or is not yet vested). In this case, the founders would receive 70/95% = 73.7% of the proceeds in Option 1, whereas in Option 2 they would receive 75/100% = 75%, i.e. 1.3 percentage points more. This is because the proceeds that would have gone to the 5% unallocated/unvested options (if they had been allocated and vested) go to the founders alone, while in Option 1 all shareholders benefit ratably from the unallocated pool, which is de facto removed from the cap table.

Here is a summary of the two approaches:

At first glance Option 2 looks more logical than Option 1: The founders owned 100% of the shares initially and agreed to allocate 10% to employees. If it turns out the 10% is not needed, isn’t it only fair and logical that the unused portion falls back to them?

Actually, it’s not, primarily for three reasons:

First and foremost, a disproportionate “burden-bearing” creates an unhelpful misalignment of interest. The founders will generally be more reluctant to allocate the ESOP if it comes exclusively out of their own pocket, preferring (somewhat) higher cash payments instead. Even if the difference between the two options appears small (in the example above 1.3% vs. >70% founder holdings), Option 2 nonetheless tends to have an impact because of the potentially high absolute value that the (unallocated) options might ultimately reach. Option 1 avoids these conflicts: Allocated options dilute, and unused options benefit, all shareholders equally.

The second reason is that in the only scenario where Option 2 has real practical relevance the fairness argument does not stack up. This is because an exit that is sufficiently successful to allow a meaningful payment to option holders hardly ever happens at a time when there is only one (not fully-allocated) incentive pool in place. Option 2 therefore generally comes with the understanding that the selective “burden bearing” continues to apply even after a pool expansion. This means that any options from the initial pool that lapse at the time of the exit (because they hadn’t vested yet) go to the founders even if there are plenty of other options from later pools that still need to be paid. This does not make sense: if it was agreed that the founders pay for X options and if because of this the investors paid a higher purchase price, the first X options to be paid out should be covered by this arrangement irrespective of which pool they where issued from.

Third, the aforementioned separate treatment of successive incentive pools in Option 2 also generates an unhelpful admin tail. The initial pool would need to be tracked in detail, option for option, over time so that it’s clear who (which shares) have to pay for what options. Simply looking at exercise prices does not help as returned options may be reissued at different prices. If you think it may still be worth the effort, consider explaining all this to future investors. :-)

So: Even though it’s tempting and feels “right” to have unused ESOP shares go back to the founders, the concept is actually counter-productive and on balance probably more value-destroying than beneficial even for the seeming beneficiaries. It’s not just the old and tested kitchen wisdom KISS (“keep it simple, stupid”) that holds a lot of truth here, but also basic considerations of value allocation and governance clearly speak in favour of Option 1.