A Comprehensive Guide to Creating an ESOP Pool
No matter how big or small a startup is, a committed workforce is key. An ESOP pool consists of shares of stock reserved for employees of a private company. It is a way of attracting talented employees to a startup – if the employees help the company do well enough to go public, they will be compensated with stock. Employees who get into the startup early will usually receive a greater option pool than employees who arrive later.
In the case of early-stage startups, employees bring in years of expertise, take a risk by joining the company at a stage where it has not found product-market fit, and help it meet its near-term goals and long-term vision. Growth-stage companies can still perhaps match standard market remuneration, but early-stage companies cannot, and thus they offer ‘deferred profit-sharing’ instead of ESOPs.
These equity shares are either awarded at the time of joining or during employment (depending on how crucial the employee is to the organization’s growth). But rolling out ESOPs is not that simple. It requires founders to dilute a certain percentage of their ownership to allocate to the ESOP pool (at an early stage). It is from this pool that ESOP shares are awarded to employees. So, unless you have an ESOP pool, you can’t grant ESOPs to initial employees. As a founder, if you exhaust the ESOP pool and still have unmet hiring needs, you can further dilute your ownership to replenish the ESOP pool or call on your investors to do so.
- Forming the core team: A sole founder is like a lone wolf at the beginning. But even the lone wolf looks to form a herd as time progresses. Today, businesses are built on the success of multiple teams working together. To make this happen, a startup requires leaders – employees who believe in the founder’s vision and push towards it. Founders can award ESOPs to either attract or retain employees who can bring value. As partakers of profits, these employees will trust the company more.
- Incentivizing top performance: Recognise, incentivize, and encourage talent in your company by giving out employee stock option plans. Top employees need to know that their performance is valued. These rewards boost their morale, pave the way for them to grow their personal wealth, and encourage them to stay loyal.
- Instilling a sense of ownership in employees: The sooner you build a loyal and committed workforce, the faster you accomplish business objectives. But for building such a team, employees need to think of the company as their own. Founders can promote this culture by offering ESOPs. With ESOPs, employees share profits with owners, making them stay committed to growth.
Having said that, some founders build businesses from scratch with a 5% pool, and there are ones who allocate a 25% ESOP pool in the early stage itself. There is no particular benchmark based on which startups should build their ESOP pool. The allocation can be anything depending on the company’s market position, investment stage, and other factors.
Creating an ESOP Pool
It is important to understand that the size of the ESOP pool and ESOP grants are inversely proportional to the company’s valuation. At the seed stage, the pool is typically about 15% of the total equity. In succeeding funding rounds, founders and other shareholders can partially restock the pool by diluting more equity.
At the growth and mature stages, the company’s valuation increases, and startups can match employees’ salary expectations. For this reason, they can reward employees with lesser grants. A good mix of take-home salary and ESOPs would be enough to attract, motivate, and retain the required talent. An ESOP pool that was 15% in the seed round might shrink down to 4% when the company raises a Series B fund.
An important question surfaces here, ‘What is the best time for founders to create the ESOP pool?’ Satheesh KV, former HR Director at Flipkart & co-founder of Spottabl, says in a webinar,
And, TN Hari, Head HR of BigBasket concurs with Satheesh. He says in another webinar, “The ESOP pool should be made as early as possible. When the company approaches Series A, the ESOP pool size should be around 10% of equity on a fully diluted basis.”
“A 10% pool is great to have in the beginning. Anything less is not that good. In later stages (say Series C or Series D), the pool might shrink down to 3 or 4% as the valuation of the company goes up,” says Deepak Abbot, a former VP at Paytm and now a founder of a startup that is in stealth mode, when he was talking about the importance of ESOPs in a webinar with trica equity.
These statements clarify that founders should focus on creating an ESOP pool from the word ‘go’. But why is an ESOP pool so necessary? Why must a founder dilute a part of equity before generating any revenue?
How can VCs contribute?
“I would advise founders against creating full ESOP pool before the VC comes in with the investment,” says Hari. “Doing this, they would end up diluting everything on their part and have a lesser stake than the VC. Founders should wait for the next fundraise to dilute to create the full ESOP pool and partner with the VC to do so. Both VCs and founders should share the dilution of the ESOP pool.”
“It’s all about the founder’s negotiation and conversation with the board telling them why the dilution is important,” says Satheesh. “If the company does well, generally, investors do not hesitate to participate in the dilution. But the plan should be uniform across different growth stages,” he continues.
A Founder’s Perspective
Abhiraj Bhal, the co-founder of UrbanCompany (previously UrbanClap), mentioned in a webinar with trica equity that having a 10% ESOP pool at a pre-seed stage is a positive sign.
In UrbanCompany, the ESOP policy is one of its kind, with an exercise price of just INR 1 and an ‘infinite’ term for employees to exercise options. “Employees have earned their ESOPs. They should be at liberty when it comes to exercise options. Giving them this flexibility helped us drive fairness and foster a culture of positivity and shared-ownership in our organization,” says Abhiraj. “Shared ownership has its perks. We have seen employees take complete responsibility for the business wings they are managing,” he continues.
Founders should understand ESOPs as a whole – when to dilute equity for the ESOP pool when to offer ESOPs, which employees to offer it to, when to grant, design the vesting schedule, and how to design the vesting schedule to manage the equity stack.Click here to read about the best practices to strategize your ESOP policy!
Employee ownership and shared capitalism as concepts are relatively new to India but have a strong impact on the startup ecosystem. Thanks to the benefits that ESOP shares bring to the table, they have become a permanent strand in the DNA of every startup. While founders leverage ESOPs as an employee retention tool, employees see these equity options as a wealth multiplier. An employee stock option plan is essentially a long-term incentive that is granted to employees to buy or subscribe to the shares of the company at a predetermined price. This way, grantees are offered equity compensation instead of or in addition to their remuneration. The benefit of ESOPs is that it allows grantees to have a stake in the company which directly results in greater loyalty and motivation.
But, founders need to understand ESOPs inside out and play their cards right as the dilution of both, founder and investor equity, is involved at every stage. Some wrong moves, and the house of cards might crumble!
To offer ESOPs, founders are required to dilute a part of their equity and carve the ESOP pool. From this pool, ESOPs or equity options are granted to employees. If the pool gets exhausted, founders and investors may dilute further equity to replenish the pool in successive fundraising rounds. The ESOP pool size is inversely proportional to the company’s growth – as the company matures, its ESOP pool size reduces. Subsequently, ESOP grants to employees decrease.
Know these before rolling out ESOPs
- Know the law of the land: The ESOP policy should be designed to comply with the laws and rules of the country in which the company is registered. Lack of awareness of local tax laws might turn out to be a hurdle when it comes to diluting and liquidating equity.
- Align the ESOP design to your vision: Founders should grant ESOPs if they find an employee mission-critical for accomplishing organizational goals. This approach would also align employees closer to the organizational vision
- Customize the ESOP policy: Build it from scratch. The plan should be flexible, employee-friendly, and suit your roadmap.
- Communication with employees: “While giving out ESOPs, have a one-on-one discussion with the team member and talk about the business to the extent you have visibility (next round of funding, exit plans, anticipated dilution, etc). Keep the plan completely transparent. Be open to feedback and give realistic numbers when employees ask about the money they can potentially make on the sale,” says Hari. It is a good practice to compare the expected wealth with the company’s growth trajectory and valuation. Let the employee have a bird’s eye view of the venture and the possibility of wealth creation.
- Offer ESOPs in units and not in value: More ESOPs should be offered to employees who took a greater risk by joining you at an early stage, as compared to employees who join at growth stages. Satheesh says, ” Suppose you offer 5000 USD worth options to an employee today, and your company raised a fund after that. A week after the funding round, if you offer the same 5000 USD options to someone else, the number of units both of them hold will be significantly different. To drive fairness, it is necessary to offer ESOPs in units and not in value”.
- ESOPs should be independent of the cash component: ESOPs don’t have to be a percentage of the cash component. “Don’t make ESOPs a part of the CTC. If you are giving more ESOPs to somebody, it is fine to offer them a lower cash component,” says Satheesh.
Founders should leverage startups as a business strategy. The ESOP policy should be designed to grow and grow fast. Every stage of the startup lifecycle is a stage of growth, and ESOPs can be good catalysts at every stage. Hari says,
Planning the growth stages
- Early Stage – Aggressive ESOP Play
In the early stages (seed and angel rounds), companies are generally less liquid. They might not have adequate resources to hire C-Suite executives and other employees who are critical to business growth. In such cases, founders should offer ESOPs aggressively as they will have a lower cash component to offer. ESOP grants can be heavy, and the policies should be flexible. Attracting employees is the main motive in this stage.
- Growth Stage – Aggressive cash play
Satheesh says, “By the time a startup raises a Series A or B round, the business has grown. Founders should try to match the cash expectations of employees and restrict ESOPs to those employees who are extremely valuable.” ESOP grants can go down, and cash components should rise. ESOPs should be offered to employees as rewards. In this phase, the retention of out-performing employees becomes the key to growth. Employees who were not granted ESOPs on joining must be offered equity options now, provided they are drivers of the business. In the growth stage, founders should leverage ESOPs to solve business problems – they should make the right hires! And, also founders should be careful with ESOPs at this stage as valuations are really high. Offer ESOPs when it is of utmost necessity.
- Maturity Stage – Balanced ESOP and cash play
After raising a Series B round, startups come to a mature stage. In these later stages, both the cash component and the ESOP pool are most likely balanced. At this stage, Satheesh suggests that founders should increase performance-based ESOP grants. As the cash component is high, ESOPs need not be offered until absolutely necessary. It is also important to know that in later stages, the valuation of the company is high, meaning the Fair Market Value (FMV) of each ESOP would also be very high. For this reason, founders should have a balanced view of the rewards that are to be offered to employees for performance. Deepak comments,Also, it is important to understand that stock options combine the founder’s motives of profit and private ownership with the desire of employees to share in the wealth they help create. A wisely strategized ESOP plan can be the silent navigator in the startup’s success story.Many unicorns have been built on the foundation of a strong and strategized ESOP policy. Founders should understand ESOPs thoroughly and incorporate them to foster a positive work culture
As a startup founder, you start offering ESOP to your important hires from day one. But many founders have little idea on how to formally start running ESOPs in the company (see FAQs). Let me walk you through all the steps required if your startup is registered in India. For startups incorporated in other countries, the steps are mostly the same with some minor variations.
- Step 1: Get an ESOP scheme prepared through a lawyer. This scheme document covers various legal clauses governing ESOP administration, pool size, grants, vesting, employee cessation, exercise period, etc. If you have raised any round of funding, it is most likely that the SHA from the round already has a provision for an ESOP pool, and the size of the pool is also quantified in the SHA. Now, the lawyer will ask you several questions to add/modify clauses in the ESOP scheme document as per your requirements. Note that it is very imperative to make sure that the scheme is drafted in a manner that is fair and beneficial to the employees; otherwise, the whole purpose of ESOP as a tool to attract and retain talent may be lost.trica equity’s ESOP Scheme Generator can help you customize your ESOP scheme and design an ESOP policy that will be tightly coupled with the organizational roadmap. Schedule a demo now!
- Step 2: Get the board approval for adopting this ESOP scheme
- Step 3: The ESOP scheme also needs to be approved through a special resolution at the shareholder’s meeting (EGM). You need to send out an EGM notice for the same and then finally conduct the EGM and pass the shareholder resolution. Note that this needs to be a special resolution (votes in favor of the resolution at least three times than votes against) as compared to an ordinary resolution (simple majority).
- Step 4: The board resolution and EGM resolutions need to be filed with the Registrar of Companies (RoC) website using form MGT14. Your company secretary can do this. There is no other filing required with the RoC
- Step 5: ESOPs are only options and not shares, therefore there is NO need to increase the authorized share capital of the company at the time of ESOP grants. It only needs to be done when an employee goes for exercise, which is usually much later.
- Step 6: Now, you are ready to formally grant ESOPs to your employees through a grant letter.trica equity makes end-to-end equity management seamless.
Schedule a demo now!
Many a time, we come across founders trying to issue a grant letter to the employees backdated to an earlier date because the employee was promised these long before the ESOP scheme got approved by shareholders. This is not legal. The grant date must be greater than the ESOP shareholder resolution date. Do keep this in mind!
When strategized properly, Employee Stock Ownership Plans (ESOPs) turn out to be the pivot around which the success stories of startups revolve. From boosting the workforce’s morale to diversifying wealth and attracting & retaining top talent, ESOPs have proved their mantle in the startup ecosystem, time and again. Today, it has become innate for every startup founder to understand ESOPs and the value they bring to the table.
In a webinar with LetsVenture TN Hari, Head HR of BigBasket – India’s largest online food and grocery store, shared his take on ESOPs. He broached all the best practices that contribute to strategizing an affluent ESOP policy.
- Get to the bottom of the ESOP DNA Despite the appeal of ESOPs, a large number of startup founders think that liquidity generation via ESOPs is extremely complicated. These founders believe that ESOPs bring value, but only on paper. ESOPs help drive employee engagement, improving the company’s performance over the years. ESOPs are liquid sources in the long run but employee-attraction tools in early and growth-stage companies.But for doing that, the C-Suite needs to understand ESOPs as a whole and come up with an ESOP strategy looking at the bigger picture. Founders should particularly educate employees about the value that ESOPs bring to the table and make sure that the company’s ESOP policy and liquidation plans are transparent to everyone who has been granted ESOPs. This will push employees to run the extra mile.
- Customize grants based on the employee’s risk-taking appetite & use FMV as Strike Price Similar-level employees who join the startup in its early-stage should be granted more options than the ones who join in the growth-stage. Early-stage employees exemplify belief in the founder’s vision right from the start, and they should, therefore, be appreciated and rewarded more at the time of an exit. Consider an employee ‘A’ joins at an early stage, and the FMV of each share is INR 200 at this point in time. After vesting, if the FMV of each stock exceeds INR 200, ‘A’ will gain an upside. If another employee ‘B’ joins the startup 2 years after ‘A’ had joined, the strike price of ESOPs offered to ‘B’ should be at FMV. Now, if the FMV is INR 300, ‘B’ should be granted ESOPs at a strike price of INR 300. This is because ‘A’ has taken a much greater risk than ‘B’ and should, therefore, be able to make more money out of equity shares.If the strike prices are equal for every employee, early-stage employees should be granted more optionsAlso, it is important for founders to understand that employees who join at a lesser remuneration or take a pay-cut while joining look forward to making up the money through ESOPs. These employees understand how long it may take for equity shares to liquidate, and nonetheless, are taking the risk. Therefore, they should be granted the privilege to make more money out of ESOPs.
- Offer ESOPs face-to-face as a preamble (and not on e-mail) ESOPs hold great value in a startup employee’s career. Considering the fact that ESOPs are complex, founders or HRs should sit down with employees and offer ESOPs in a face-to-face discussion. The management should explain the ESOP scheme document & tax implications related to exercising and selling ESOPs.It should be clear on the employees’ minds that ESOPs are not just money on paperEmployees should be briefed about the KPIs of the business and the roadmap of the business 4-5 years down the line. They should also be presented with an approximation of the stock price when the vesting period ends and the estimated wealth they can create after the liquidation of the granted options. This process will not only educate employees about ESOPs but also encapsulate them strongly with the organizational vision and roadmap. Therefore, founders or senior management needs to answer all questions, deal with the skepticism, and communicate a value proposition to employees.
- Make subtle adjustments to the size of the ESOP pool The ESOP pool size should be directly proportional to the people and management skills of the founder. Some founders build businesses from scratch with a 5% pool, and there are ones who allocate a 25% ESOP pool in the early stage itself. There is no particular benchmark based on which startups should build their ESOP pool. The allocation can be anything depending on the company’s market position, investment stage, and other factors. However, it is advised that founders should not dilute the ESOP pool when the VC comes in with the investment. Doing this, they would end up diluting everything on their part and have a lesser stake than the VC. Founders should wait for the next fundraise to dilute the ESOP pool and partner with the VC to do so. Both VCs and founders should share the dilution of the ESOP pool.
Here’s the link to the full webinar:
Deepak Abbot has proved his mettle in the startup world as an all-rounder who can do anything from product management & web development to analytics & marketing. Deepak joined the early product team in Paytm in 2013 and, in a five-year run, drove engagement & created marketing impact to become a Senior Vice President. Now, Deepak has taken the entrepreneurial plunge and is building his own startup.
In this webinar with trica equity, Deepak talks about how employees should approach ESOPs. He explains ESOPs from an employee’s perspective – what must you negotiate for at different levels and stages. Listen in to this webinar if you want to understand the entire ESOP lifecycle from entry to exit. Deepak has been honest and candid and provided “real actionable” insights on approaching various situations from entry to exit.
Why are ESOPs important?
Abhiraj Bhal, an IIT-K and IIM-A alumnus, is one of the three co-founders of UrbanCompany (previously UrbanClap). Founded in 2014, UrbanCompany, one of the largest home services platforms, has grown to become a unicorn today, recently extending its footprint from India and UAE to Australia and Singapore. UrbanCompany is considered one the Indian startups with a very progressive ESOPs policy, and in the six-year journey so far, the company has had two liquidity events paving the way for employees to multiply their personal wealth and take what Abhiraj describes as a “water cooler” moment in the marathon of building a startup.
In a conversation with Megha Viswanath from CNBC TV-18, Abhiraj and Sanjay Jha (Co-founder of trica equity) discuss the importance of ESOPs as a whole. They talk about why building an ESOP Policy early on is thoughtful and reflects the founder’s core philosophy and culture, and is beneficial in building trust and ownership within a company. They also discuss some of the best practices that can be incorporated to design an ESOP program – equated annual vesting, the exercise price of a rupee, and accelerated vesting in case of a strategic sale. Other highlights from the discussion are:
- Prioritize ESOPs as a preferred equity grant
- Have an employee-friendly ESOP policy or don’t have it at all
- Avoid ‘bait-and-switch’ ESOP schemes. Your employees will feel cheated
- Educate employees about potential wealth creation possibilities
Watch the full webinar here:
“Though ESOPs are popular and extremely fruitful, they are far from being adopted on a large scale. This is because most founders do not understand ESOPs well. Most Indian startups create ESOP pools after raising their first institutional fund, and not before that,” says Ritesh Banglani, Founder of Stellaris Venture Partners. Ruchi Deepak, Co-founder of Acko Insurance, continues:
A bold view and not one that you will find a lot of founders articulating openly, but this is one of the many realities of the startup ecosystem in India – though founders understand the benefits that ESOPs bring to the table, they fear that VCs might not necessarily dilute a part of their equity to top up the ESOP pool when the time comes. In this scenario, founders end up diluting a substantial part of their stake in the company, thereby compromising the negotiation power they will eventually have. Ritesh says,
”Consult with your mentors, advisors, and angel investors, and carve the ESOP pool from the very beginning. Make sure that your ESOP policy is aligned with the organization’s vision and roadmap,” he adds.
The FreshWorks for Startups webinar on ‘Understanding ESOPs and their importance in startups’ was conducted in association with trica equity, a SasS product for founders to manage their cap table and ESOPs without the errors and messiness of multiple Excel sheets.
The panelists, Ritesh and Ruchi, started the session by explaining ESOPs as a whole and went on to talk about address some of the most common questions founders have:
- When to create the ESOP Pool?
- Who should be granted ESOPs, and how much?
Salary versus ESOP
“Startups, at an early or seed stage, are cashflow deficient. Founders, therefore, leverage Employee Stock Ownership Plans (ESOPs) to lay the foundation of a committed workforce and address the dire need of scaling the company faster,” says Ritesh.
Maintaining & topping up your ESOP pool
Rolling out ESOPs, however, can prove to be very tricky. If a particular framework is not followed, the ESOP pool will dry up in the early stage itself, and founders will have to dilute more of their equity to refill the ESOP pool. Ruchi says,
The ESOP framework is essentially an internal guideline (not legal) that should be followed to grant ESOPs. The framework should define the set of employees who are to be granted ESOPs, the number of grants, and the type of vesting to be incorporated.
Ritesh continues, “ESOP awards should be based on two factors – the amount of risk that an employee has taken, and the value that he/she has added to the organization. Use valuation as a proxy to roll out ESOPs. ESOP grants should always be inversely proportional to the valuation of the company. ESOP grants should be less at higher valuations, and vice-versa.”
Watch the full webinar:
How much will it cost employees to exercise their options?
The exercise price is the cost of exercising an employee’s options, which is determined on a case-by-case basis for each employee. The exercise price is usually fixed at the market price of the company’s shares (typically decided with reference to the latest completed funding round), at the time the options are granted. Employees profit as the company’s value increases from the time they were given their options.
How long will employees have to exercise their options?
An option’s expiry date is the last day on which the option holder can exercise the option. This is usually in line with when the company expects to find an exit. This is usually about 7-10 years from the date of grant, although this can vary depending on the stage and maturity of your company.
If an employee leaves the company, the expiration date may change. When an employee leaves, most employee-friendly ESOPs do not adjust the expiration date. As a result, leavers are not compelled to exercise their options before an exit event. Some organizations, on the other hand, choose to give leaving employees a shorter period of time to exercise any vested options, such as up to one year after leaving the company. The company’s administrative cost of keeping track of departing employees with options is reduced as a result.
What is the timetable for the options to vest?
Almost all options vest over a three- or four-year period. Employees are encouraged to stay with the company for the duration of the vesting term to exercise all their options in the future. In most cases, if an option holder leaves before the expiration of the vesting period, their unvested shares are forfeited. Employees who have been with the company for a long time before getting options may benefit from shorter vesting periods.
What happens at an exit event?
Single-trigger acceleration is enabled on exit, which means that all unvested options vest and can be exercised in full on exit. The partial or complete acceleration of vesting of someone’s options or shares depending on the occurrence of a single event, i.e., that event provides the “trigger” for acceleration, is known as single-trigger acceleration. The most employee-friendly position is single trigger acceleration, which encourages all parties to push for an exit as soon as feasible.
Single trigger acceleration, on the other hand, may deter potential acquirers of the company, as they often desire key employees to stay on after the sale, and hence continued vesting of options enables that. As a result, some companies prefer double trigger acceleration to make their company more appealing as an acquisition target.