An ESOP scheme has been in practice for decades and was meant for senior employees or management team members who worked for a long time and decided to retire. But lately, this scheme has been adopted by startups as a way to keep up the workforce as consistent as possible. When we talk about the ESOP pool, it means the pool for shares and its options established for the employees, directors, and other company working members that contain shares for purchase. In the case of a corporate issuing ESOP, it has all the power and authority to execute the agreement it hands out to the employees and workers. The sense of ownership creates a productive workforce that continues to do well for the reward to be received.
The grants of the ESOP are inversely proportional to the company's valuation, and over-expansion can dilute the shares. With time, the ESOP pool can be expanded as per the necessity and demands of the corporate and its hiring needs and can range from a small percentage of 10 percent to 20 percent from the start.
To create an ESOP pool, several steps and measures need to be considered, especially for a startup.
In the initial stage, founders often look for fundraising after having reached a certain level of establishment. The hiring is mainly done for the development of the product or service. At this stage, it is crucial to think of the employee requirement of the company, post which the ESOP pool can be made large enough to distribute amongst the employees or recruits. Since it is at the initial stage of its establishment, the company cannot afford to pay a competitive amount of salary, which is why ESOP is introduced to compensate for the low pay.
After the ESOP scheme has been issued, an employee's eligibility to invest in ESOP depends on the value they bring to the company. While determining the size of the ESOP pool, it is better to start at a minimal size, which is around 10-15 percent and can be expanded with time. However, the initial pool size depends on the hiring requirement. The ones who join at the early stage are likely to receive more options from the pool than those who join later. If the pool size is too small, it won't be able to leverage the scheme to hire talented employees, and the opposite will end up with diluted ownership. So, determining the ESOP pool size is a prerequisite to the initial stage of creating an ESOP pool.
Series A and B Stage
This stage comes after the startups have already developed their products or services and aim to hire employees that can build a foundation for scaling, like growth marketers and sales specialists to acquire more customers and clients. At this stage, the startups have enough revenue to pay the employees, and thus, the new recruits are taking lower risks as compared to the employees who joined at the initial stage. Existing investors dilute their equity while creating a new pool, and the ESOP pool size can come down to 7-10 percent equity for the new recruits as they are joining during the growth.
The new investors are likely to ask for fresh option pools even if there are unallocated options from the previously created pool, which can end up overdiluting the existing shareholders' ownership. The company's founders can refuse to do so by showing that the previously created pool is enough for hiring new recruits and anti-dilution provisions.
This is the series C, D, and beyond stage, wherein the startup has a product-market fit and is comparatively more stable than the previous stages. Usually, at this stage, startups buy back the ESOPs to help create employee wealth and give rewards for their contribution, and they do not need to wait for years for the startup to go public. The ESOP pool options are usually given to the ones who have contributed the most and have added greater value to the company. With the rise in the valuation of the company, at this stage, the pool size normally comes down to 5-7 percent, and the options are given selectively to incentivize growth.
Communicating the values of ESOP
The ESOP scheme can be new for most new employees who might not understand the value and functions of the scheme. Giving the ESOP pool options to the new employees will not be able to leverage the scheme and further dilute the equity; thus, distributing the pool to the right employees is an effective way to retain and motivate the existing shareholders. The new employees are more likely to expect cash bonuses over a scheme like ESOP, which is timebound and might not be seemingly worthy of their investment. Communicating the benefits of the ESOP scheme and its potential to create wealth in the long term is necessary to clear doubts regarding the scheme.
The Employee Stock Option Plan has been around for decades and has proven to be a great tool for benefitting the companies and their dedicated employees. Creating an ESOP pool is basically broadening the option of stock for the employees and giving a higher number of options to those who have brought the company to the market and helped it hold a strong position. The employees who join right from the start will expect more stock options, and therefore, a higher number of options is given to them. However, the ESOP pool size needs to be determined before giving out the shares, as too less of it can fail to leverage from the scheme, while too much of it can dilute the equity. The perfect amount can be calculated by estimating the company's requirements and its hires.
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