First, know thyselfFounders, when structuring your ESOP (employee stock ownership plan) it’s helpful to ask yourself some fundamental questions. Quite simply, what sort of company are you setting out to build and how long is it going to take you to reach profitability? If you’re a Technology company with a mandate to develop, license and support technology solutions and/or new market infrastructure which you’re building from scratch, then you’re going to need to put in place an employee options pool large enough to enable you to retain and incentivise your growing team whilst you’re still pre-revenue. Investors won’t look kindly on you paying out cash bonuses until you’ve demonstrated a pathway to profitability and it’s entirely possible that you may not break-even on your cashflow until much later (e.g. Years 3-5), which means that you need to set up your ESOP for the long haul.
Then, fill up the tankAs founders will learn when they go through different rounds of financing, the mysteries of financial modelling coupled with the effects of funding dilution will ensure that shareholding percentages will never equate to round numbers, but a reasonable assumption is that by the time you’ve stopped selling equity to finance your growth (pre-IPO), investors will hold around 60% of the company, the original founders will hold around 20% and the employees will hold around 20% via an ESOP. Most companies will initially set aside between 10-15% for employees when they do their Series A fund raise, in the knowledge that they will have to agree with current and future investors to top this pool up in later funding rounds as they travel towards the 20% end state mentioned above. The first valuable step every founder should take when considering how best to set up their ESOP is to know what their business plan entails for the upcoming “leg” of the journey. In other words, what are you putting yourself on the hook to deliver before the investors’ money runs out and you have to go back to the funding well.
Then, get help from an expertSince you will need an exact number for your funding term sheet, determining the size of the initial employee pool is made easier by sitting down with an expert who will look at the business plan and help develop your People Strategy by answering questions like:
- who are the key hires you need to make to form your Day 1 management team;
- how much equity do you want to grant to each key hire grant up front, and how might their ownership increase over time, bearing in mind that there may be some big hires to accommodate Day 2;
- how many other people will you hire in total in Year 1 / Year 2, on the assumption that no-one joins a start-up without getting at least some equity;
- and how much equity should you hold in reserve in case an unexpected opportunity to use it pops up.
Finally, find your balance
Don’t forget that you will need to find a way to balance out employee ownership stakes over time because not everyone’s true long term value to the company will be obvious on Day 1.
Once you have granted equity to an employee you can’t get it back, so you need to build flexibility into your allocation methodology and be careful about how your spend this important currency.
You will also need to develop a philosophy for how you plan to make additional grants to both incoming and existing employees in Year 2 (and beyond), and how you plan to communicate the value of these grants to your team.
As a final thought, founders please remember – your equity pool can be the most valuable commodity you have to ensure you achieve your vision. Cash funds from investors are important because they pay for salaries and OPEX bills, but your ESOP should be used judiciously to incentivise the people who will open doors and move mountains for you.
We will cover some of these very important factors in future blog posts. Clear communication and a consistent philosophy are critical enablers for developing the strongest working culture. If you’re a founder and would like to discuss designing your ESOP please reach out to email@example.com