ESOP 101 for Early-Stage Founders
Employee ownership has been one of the defining factors of Silicon Valley’s success and dates back to the 1950s. We’ve all heard stories of mid-level employees walking away from exits with meaningful payouts, or even stories like that of Graffiti artist David Choe who was paid for his work in Facebook equity and took home $200 million. An automated, metaverse-driven future may be on the horizon but for now talent is the driving force of any private enterprise and the recipe for hiring and retaining top talent is values + culture + ownership.
A number of early-stage founders have approached me recently on the topic of ownership, asking for help with the issuance of ESOP, or ‘Employee Stock Ownership Plans.’ As I dug around online for reputable resources to direct folks to, I quickly realized that there is a pronounced lack of clear information on this important topic, especially in the MENA region. While there are several detailed guides written by investors that are available online, they are often hyper-specific and document unique case-by-case scenarios; alternatively, the how-to’s put-out by law firms are mired in complex legalese and riddled with caveats.
** While we’re on the topic of caveats, this is a great time to point out that nothing written here should be construed as legal advice. Please always consult with a reputable attorney or legal team (you get what you pay for) and your trusted advisors to determine what works best for your company. **
And so, given that ESOP is a common topic of inquiry for founders ranging from Dubai to San Francisco, I decided to jot down my observations and offer helpful supplementary materials that have cultivated my own understanding of ESOP over time.
What is ESOP?
ESOP stands for “Employee Stock Ownership Plan.” This term encapsulates various forms of stock option grants given to employees as part of their incentive package. For those who require a referesher, a stock option is a right (but not an obligation) to purchase a given quantity of shares in a company at a set price for a fixed period.
While there are other forms of equity compensation, ESOP is the most widely used in the early-stages of funding. Some later-stage companies will transition towards restricted stock units (RSU) and even phantom shares. For the purposes of this article, we will focus primarily on options, but it’s worth spending time on Carta’s deep-dive on options vs. RSUs.
The Purpose of ESOP
Many companies ranging from startups to corporates offer some form of equity incentives to their employees and venture capitalists will almost always require ESOP when investing in a company. Equity-based incentives serve a multitude of purposes, including:
Compensation: Options serve as a component of a prospective employee’s overall compensation package. They can also act as a valuable supplement to salary, especially in the early-stages of a company when cash salaries are limited by budget.
Incentive Alignment: Employees become shareholders through options, aligning their long-term incentives with the company. Options typically can’t be sold unless there is a liquidity event. In this sense, options encourage employees to focus on the macro vision in building long-term value for the company.
Retention: Vesting schedules can create strong incentives for employees to remain with the company and stem turnover, usually for a minimum of three to four years.
Building the Option Pool
If this is your first fundraise, your starting point must be to decide on the size of the option pool. Option pools should be large enough to accommodate all hiring and retention grants between funding rounds. For the moment, let’s set aside any preconceived notions of how large an option pool should be. There are two common methods to allocating ESOP but both are built using your hiring plan.
Your Hiring Plan
Your hiring plan should include all required roles forecasted between your current financing round and your upcoming financing round. While I strongly believe that attempting to forecast the trajectory of a startup beyond even a few months is futile, human productivity is more predictable and there is clear precedent for how many engineers, product managers, marketing executives, etc. you need based on what you’re looking to achieve.
Allocation of ESOP
Allocations are more of an art form than an exact science but, in general, there are two approaches:
Method 1: Allocation as a Percentage of Salary
This is the more granular and scientific of the methods. The idea here is that the options allocation should represent a multiple of the employee’s annual salary; this allows for the implementation of a clear ESOP policy and front-loads the decisions around the differentiated multiples for specific roles within the company. For instance, in the MENA market specifically, the multiple may be potentially higher for product manager or engineer roles given the scarcity of that particular talent in the region and the essential nature and relative importance of those positions to the company infrastructure.
Fred Wilson, managing partner at New York City-based Union Square Ventures shares his own allocation approach in a recent blog post he penned on the topic.
“Here’s a formula I like to use. Take the cumulative salaries of all the hires you need to make between the current financing and the next one. Let’s say it is five employees at an average of $75,000. Then that number is $375,000. Then divide that number by the post-money valuation, in this case $5mm. That gives you 7.5%. That’s the size of the option pool you’ll need. And it is conservative because I don’t recommend giving options equal to the dollar value of the annual salary of your hires. I like anywhere between 0.1x to 1x (depending on role and responsibility), with the average being in the .25x range. But early on in a company, you will need to and want to be more generous.”
Bear in mind that you need to calibrate this according to your company’s salaries relative to market salaries. For instance in MENA, Careem was known to pay below-market salaries but compensated with generous ESOP grants so using a salary multiple of 2x to calculate ESOP in such cases would still be considered reasonable.
Social-media management platform Buffer published an excellent example of a formula they built and shared publicly (take note on their value of transparency) here. You can use this for inspiration, guidance, or to assess opportunities with their team.
Method 2: Allocation by Benchmarks
I’m less partial to this methodology especially because in areas like the MENA region, the specific cap table data that is required to build such benchmarks is often kept carefully guarded and in most cases, investors themselves rarely have access to the information. However, there are exceptions: the founders of AngelList- Babak Nivi and Naval Ravikant- have shared some benchmarks based on data from Silicon Valley:
A few caveats:
The above ranges are indicative only and should be used as benchmarks at early stages rather than regarded as the ESOP gospel.
More experienced candidates can command higher ESOP.
The above table includes c-suite roles. In MENA, while most companies I’ve seen fundraising have a CTO or CEO, I commonly see companies fundraising with the intent to hire a CTO at around~5%.
As the company grows and raises successive rounds of funding, the risk to new employees decreases and (in theory) the company is more liquid. This may lead to a shift towards more salary-based remuneration versus incentivizing employees with option grants.
In general, it is important to remember that not all employees are created equal, and ESOP is a tool that should be used in proportion to the value-add of the employee receiving the grant.
Option Pool Size
I intentionally left this section for last. Why? Because the most common response when a founder asks how he or she should think about ESOP is usually some iteration of: “You should set aside roughly X% for employees.” Each company needs to do the work to determine what percentage is right for them rather than simply accepting an anecdotal number.
ESOP allocations vary significantly by region, investment stage, founding team composition, and sector. A high-level benchmark is to aim to allot 10–15% of shares for ESOP. However, if you are a solo-founder and planning to fill key leadership roles, you will need to increase the size of your option pool accordingly (see method two above).
In my experience, on teams where key leadership roles have been filled, I have never seen an option pool larger than 15% and I can’t recall seeing a pre-money pool below 10%, but again, there are always exceptions to the rule.
ESOP pools can and must evolve depending on the progress and position of the company. Good founders and investors recognize that the success of a startup is based on the strength of its team and building a healthy team requires the right incentives. At every fundraise, you should reassess your hiring needs and plan to “top-up” your ESOP pool accordingly. Bear in mind that the value of your options will (hopefully) increase as your company grows and your allocation methodology will also need to evolve; you may even consider moving to RSUs at a later-stage. Good investors will work with you to ensure that you maintain a healthy allocation of ESOP and/or RSUs as you progress through your different stages of growth and funding.
If we think of ESOP as a car, the vesting schedule is the engine. As noted above, one of the primary goals of ESOP is to align the long-term incentives of the employee with that of the company. If an employee is a valuable contributor, he/she should be incentivized to stay with the company for the long-term. Considering the alternative, data shows the average tenure for an employee at a startup is two years; it would be unreasonable and damaging to the company to give a full equity package up-front.
Here, the calculations are much more straightforward. Best practices at tech companies in the U.S. and across MENA suggest using a four-year vesting schedule with a one-year cliff. As of late, however, some experienced investors are calling for a reimagining of the standard vesting schedule which could mean longer vesting periods, assigning different weights to each year of vesting, or even issuing different types of forward-looking “refresher” grants. These are not standard but ever founder needs to consider what’s best for the company and their employees.
Company Constitution & Jurisdiction
One important consideration when issuing ESOP is the company’s constitutional documents. ESOP must be issued in accordance with these documents and depends on the jurisdiction where your company is incorporated. The company’s jurisdiction determines how flexible the constitutional documents will be with respect to the ESOP. This is something you should discuss in detail with your legal counsel.
Options’ Strike Price
Owning options which have no real value to them is about as useful as owning Dogecoin. If your company’s ESOP is perceived as inadequate or unfair it’s more likely to have the opposite to intended effect on employee retention and motivation. Some companies offer discounted strike prices. This is a complex topic in itself and there are accounting, legal, tax, and dilution considerations at play for the company. It’s also highly dependent on the jurisdiction in which your company is incorporated.
On this topic I agree with Neil Rimer of Index Ventures:
“Issue options at the lowest strike price you can. Maximize the financial benefit to the employee, and therefore the motivational benefit you can get from a given number of options granted.”
While not a consideration for GCC markets, employee equity grants are sometimes subject to unfavorable tax treatment. Additionally, the tax exposure is dependent on the type of equity program. You should work with tax experts in your jurisdiction to understand potential tax exposure to ESOP recipients and urge them to consult with their personal tax advisors.
Pre-Money vs. Post-Money Option Pool
There is an ongoing debate as to whether option pools should be considered pre- or post-money. While this is a tenuous topic in and of itself, the common practice is for the option pool or option pool top-up to be considered as part of the premoney valuation. However, you should be aware of what this means and the implications as it relates to all involved investors given ESOP equity pools are generally considered dilutive capital.
Unallocated / Vested Shares at Exit
At the time of a liquidity event, shares are typically distributed to investors in proportion to their ownership stake. This is common practice and there’s plenty of precedent for dissolving ESOP this way. However, there’s another argument that, because founders usually create the initial ESOP pool using their own equity they should receive all or most of the unallocated ESOP at exit. I, and other like-minded investors, believe this creates a misalignment of incentives whereby the founders could be more reluctant to issue ESOP if they’re expecting a larger share of the exit proceeds. In this scenario it would be difficult to attract top talent and all shareholders would ultimately be impacted. Tilman Langer, General Counsel at Point Nine, wrote a great piece on the long-term impact of this “burden-bearing” by founders in early-stage investment rounds.
Exercise periods are the periods of time in which an employee has the legal right to exercise his options at the awarded strike price(s). These periods typically range from three months to ten years. In the past, the precedent of three months was set by companies to simplify tax considerations, however; many companies as of late have shifted to longer exercise periods. If employees don’t have the financial means to purchase the options at their strike price within the exercise period, they risk losing them forever.
ESOP requires a great deal of up-front consideration but it is a necessary tool for compensating employees and aligning their long-term incentives with those of the company. Any planned ESOP allocation should be well-planned, always based on the hiring plan of the company, and include reasonable vesting periods. It’s worth investing time and money to build your ESOP correctly from your first fundraise. Working with trusted advisors and your investors to ensure that your available option pool is adequate for the goals and vision of your company will save you time and hassle down the road.