How Much Equity Should Be Kept Aside for ESOPs?

Employee Stock Ownership Plans (ESOPs) involve converting options into equity shares, which can dilute existing shareholders' ownership, including the company's promoters. When implementing an ESOP plan, a crucial decision is determining how much equity the promoters should allocate for this purpose. This decision must consider the perspectives of both stakeholders: the promoters, who seek to maintain control and influence, and the employees, who view ESOPs as an attractive incentive. Striking a balance between these interests is essential to ensure the effective implementation of an ESOP plan while maintaining the company's stability and employee motivation.

From the shareholders’ point of view the first call is about whether to accept employees as co-owners and partners in sharing the wealth created. If the answer is no, then the alternative is to look at Cash settled Options (also known as Shadow or Phantom options). However, if the answer is yes, the decision on extent of dilution depends on:

1. Number of employees: Number of employees to be covered under the plan means that more employees would need more shares hence higher dilution of the company’s ownership structure.  

2. Objectives of the Plan: If the aim is to make ESOPs a part of the compensation (performance reward), the plan will have to run for a longer period, requiring bigger equity pool. If the intention is to help retain the core team, the pool will have to be adequate to be a deterrent. Usually, potential income that ESOPs generate over a period is in multiples of the fixed Cash compensation. If the objective is to promote broader employee ownership the Plan would need bigger equity allocation.

3. Term of the Plan: If the employers want to make it a one-time event (e.g. entry of a new Investor, IPO of the Company, silver jubilee of the company), equity pool needed would be much smaller but if they want to make ESOP Plan a part of the compensation scheme, they need a bigger and adequate equity pool.  

4. Existing equity base: This in turn depends on the nature of business. For instance, an Infrastructure company or a NBFC needs to have a large capital base from inception and would need lower pool (in terms of %) as against a Software or an Internet start up for whom a smaller % of equity would suffice given their higher valuations from initial stages.

5. Exercise price: If options are issued at a discount to the fair market value, less shares are needed to give the same amount of benefit, thereby leading to lower dilution.  

Usually, employers think that having a smaller equity pool means less benefits to employees, but this is not necessarily true. It is possible to give more benefit with lesser shares by tweaking the terms, type of instrument, etc.  

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Recommended Reading: Why ESOPs are More Than Just a Financial Incentive

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By norms, any ESOP plan to be successful requires it to be sustained for a longer period because ESOP by definition is a long-term incentive. The pool size should be adequate to suffice for allocation over 4-5 years. In case of listed companies, dilution is calculated based on the Outstanding number of Options. Exercised Options converted into shares are not considered as a part of dilution. At the cost of generalizing, the thumb rule is that dilutions are in the range of 2% – 5% in case of large established listed companies, whereas the same in case of unlisted early stage companies it is between 10% – 12%. Any equity-based instrument is a costly instrument for the employer, its judicious use is essential. The Equity pool allocation has to be done bearing this in mind.

The decision regarding the amount of equity to allocate for ESOPs should strike a balance between the interests of the existing shareholders (promoters) and the employees. It's a decision that can impact ownership and control within the company and must be made with the long-term goals and dynamics of the business in mind.