Why size matters when it comes to employee share option plans

- July 10, 2024 5 MIN READ
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There are many competing priorities that founders must juggle when running a startup and the temptation to cut corners is great but there are some corners that shouldn’t be cut… your Employee Share Option Plan (ESOP) is one of them!

Why? Well, because as I’m about to show you, ESOPs impact everyone from employees, investors, founders and the company. The implications of fucking it up can run into the millions of dollars for each party.

This article will focus on the impact of fine tuning one part of ESOPs which is the size of the option pool… this is an afterthought for most but hopefully not after you read this article!

Let’s do this…

NOTE: During this article, I’ll talk about ESOP pool sizes a lot. This practically refers to the number of options that the board and investors have approved to be granted to your employees under your employee share option plan.

For example, you have set created an option pool equal to 10% of your company’s outstanding shares which you can grant to employees as you hire them and as bonuses at your discretion as management.

Size matters

Your massive ESOP don’t impress me much.

….Unless it’s too small….

So, I’m actually impressed by appropriately sized ESOPs.

So, yes, size matters with ESOPs.

Why do appropriately sized ESOP pools impress me? Well, because they show that a lot of thought, understanding and negotiation has gone into your ESOP. It shows that you understand dilution and its impact on investors, founders and the company.

So, please don’t take your investors’ word at face value when they tell you to setup a 10% option pool and be done with it…

Do the work!

Figure out what you really need.

It could be worth an extra couple of million shmackos to you!

(I’m not impressed by ESOP pools that are too small as it means that you are skimping on rewarding and incentivising employees.

Why does size matter?

Traditionally, the issue is that it is likely that the size of your ESOP pool doesn’t actually reflect how much ESOP you require between now and your next funding round.

For example, you may create a 10% ESOP pool at a seed round which gives you 10,000 options to allocate to your employees but the data suggests that most companies only end up allocating something like 2,500 options which means you’ve got 7,500 options left unutilised.

And yes, the unallocated options are left sitting there to be used at any time but the problem is that you paid a heavy dilution to issue them all at once rather than top up the pool as needed. Also, the total ESOP pool gets factored into the share price at each round and the larger the option pool then the lower the share price and the lower the share price then the more shares each investor gets which dilutes you as the founder more.

As you can see in this graph, over 50% of companies have utilised less than 50% of their ESOP pools (Thanks to my friends over at ESOP software Qapita for the data).

How much is it worth to me?

Simply, a lot!

Mathematically, I’ve done the work to prove to you that unallocated options are very expensive… the results even surprised me!

I modelled out an example which uses the same ESOP allocation schedule across the same capital raise execution plan from pre-seed to series C. The results show that the larger the option pool the more value that the founders forego to investors.

Note: I’ve included the two different types of ESOP pool sizing methodology that I know of which are fixed and floating pool sizes. I’ll get into more details about these later.

Interestingly, the larger the option pool then the less value that your ESOP holders also get.

Why is this?

Well, because the ESOP pool size negatively influences the pre-money share price for each round and the value of your employees options/shares are set off the company’s share price. This is because the ESOP pool is included in the number of full-diluted shares. So the larger the ESOP pool then the lower the share price which results in investors getting a larger quantity of shares for their investment.

Let me show you:

So the next time an investor suggests an ESOP pool size then politely ask them why they suggested that number. Then, pull out your prepared ESOP allocation modelling to push back and fight for an appropriately sized pool that doesn’t result in you and your employees losing millions in value.

Next, I’m going to show you how to determine an appropriately sized ESOP pool.

Determining appropriate ESOP pool size

To determine an appropriately-sized ESOP pool that limits your dilution and ensures that you have a healthy utilisation rate (aka equity burn rate) then you’ll need to do a few hours of forecasting work but that should be worth a good couple of mill one day!! Not bad for a few hours of work!

When forecasting the size of your ESOP pool there are a few key considerations:

  1. Industry Standards and Investor Expectations: Typically, ESOP pools range from 10% to 20% of the company’s total outstanding shares so if you want to argue for a lower pool then you need to state your case.
  2. Cap Table Model: Before you can model your ESOP allocations, you’ll need to model your cap table based on your next few forecast capital raises as you’ll need the forecast share price.
  3. Future Hiring Plans: Carefully consider and forecast the roles that you plan to hire over the next ~3 years.
  4. Employee Remuneration: Forecast how you want to remunerate your employees paying attention to the salary and ESOP ranges for different roles as well as frequency of ESOP grants (eg. do you expect to award employees ESOP once upon hiring or are you likely to award additional bonus ESOP allocations each year. What about when you promote employees? What about employee turnover? etc)
  5. Company Growth Stage: Earlier stage companies will likely require larger pools than later stage companies in order to attract initial hires/talent in lieu of high salaries.

Variations in ESOP pool sizing methodology

As touched on prior, there are either fixed or floating ESOP pools which you can top-up differently depending on which strategy you adopt.

Here is the way to apply the different types of pools:

  1. Floating Pool: These are pools that automatically adjust in size over time based on the company’s number of outstanding shares. Eg. You may say that our ESOP pool will always be 10% of our company’s number of outstanding shares so every time we raise a new round of capital and issue new shares then the pool will automatically increase.
    1. Downsides: Very dilution heavy
    2. Upside: Very admin light
  2. Large Fixed Pool: This is when you establish a large pool upfront to cover something like the next 3 – 5 years of hiring and remuneration requirements. Eg. You setup a 15% – 25% pool today and won’t need to top it up again over the next few rounds of capital.
    1. Downsides: Dilution heavy
    2. Upside: Admin light
  3. Just-in-Time Fixed Pool: Create a smaller fixed pool that only covers the hiring and remuneration needs of your business (plus a buffer of say 25%) until the next capital raise. I call it ‘Just-in-Time’ based on the Just-in-Time inventory model.
      1. Downside: Higher admin (legal, board and investor approvals required each time to top-up)
      2. Upside: Minimises dilution and maximises founder and employee holding value.

    *  Warwick Donaldson is the founder of CapXcentric. This post first appeared on his Substack, The Aussie Startup Capital Nerd. You can read his capital raising tips and insights here.

    Disclaimer: The information provided in this article is for informational purposes only and does not constitute legal, financial, tax or investment advice. This content is intended for companies and startups and is not directed towards investors. Readers are advised to consult with a qualified professional before making any business decisions. Warwick Donaldson make no representations as to the accuracy, completeness, or reliability of any information provided in this article. Readers use the information provided at their own risk.