As a founder, the equity in your company is one of its most significant assets. Building a successful company requires leveraging capital and giving tangible benefits to your employees.
One of the compelling propositions is granting stock options to your employees. However, in employee stock ownership plans (ESOPs), ownership is necessary for hiring and retaining talent that requires building an ESOP pool. In this article, we discuss some of the critical factors to help you determine the size of your ESOP pool.
What is an ESOP Pool?
An ESOP pool is the employee-only portion of a company’s shares. Usually, it is a certain percentage of the total equity on a fully diluted basis instead of a certain number of earmarked shares. For example, if you own 20,000 shares of the company and create an ESOP pool of 1,000 shares, there are 21,000 on a fully diluted basis.
Purpose of ESOPs
ESOPs are truly the lifeline of start-ups and companies. Research says that ESOP companies have better job retention than their non-ESOP counterparts. Here are some of the benefits of granting ESOPs to the employees:
- ESOPs spare equity for employees and create substantial ownership in the company
- Helps in retaining talent for the success and growth of the company
- Assists in obtaining liquidity on a tax-favored basis
- Helps in encouraging productivity among employees
Factors to Consider when Building an ESOP Pool
The creation of an ESOP pool is a prerequisite for issuing ESOPs to your employees. The size of your ESOP pool depends on the investment stage, company size and valuation, future hiring, and cash flow. Let’s have a look at them:
1. Valuation of the Company
The constitution of an ESOP pool results in the dilution of shares. As you raise capital for your company, there is a dilution of pre-existing shareholders. This dilution of your company is inverse proportional to the valuation of your business.
ESOPs granted to an employee in the past go through the same dilution. Your employees may deem this unfavorable. However, you can achieve the right balance in your enterprise scale-up and employee stock compensation by managing the resulting dilution time. This also helps in the effective management of the cap table.
While there is no fixed formula for determining the size of the ESOP pool, 10% to 15% works well. You will be able to expand it further in future rounds of funding.
2. Cash Flow
It is essential to determine if your company has the financial resources to sustain and operate an employee stock ownership plan. By conducting a feasibility study, you can determine the following:
- Understand the company’s cash flow
- The company’s ability to pay ESOP loan debt
- The parameters for compliance
- Estimates for repurchase obligation and how the company will handle this
By assessing the extra cash flow to devote to the ESOP and its sufficiency, you can estimate the size of your ESOP pool.
3. Hiring Requirements
One of the best ways to assess how big your ESOP pool needs to be is to determine your company’s hiring requirements. Then, you can look at which positions are required to fill to attract critical hires.
You may have to increase your ESOP pool size for early employees and C-suite level executives to offer them proper incentives to join your company. It is important to chalk out a plan to avoid over-granting equity since you have a specific amount to begin with, and you have to prevent dilution.
4. Company Size
As we now know, the size of an ESOP pool needs to accommodate both new hires and dilution. Employee stock option plans tend to work best for companies having at least 20 employees. An ESOP pool size of between 10% and 15% usually works out between companies, investors, and employees.
As a founder, you need to strike a rightful balance while determining the size of your ESOP pool. Therefore, sizing an ESOP pool depends on making informed decisions and taking care of the above factors.