Companies offer employees stock options to attract and retain talent. These stock options are given from the equity pool reserved for employees, known as the option pool (or ESOP pool).
But the creation of the ESOP pool also means dilution of the shareholders' equity in the company.
So, what's the right ESOP pool size to attract, motivate and retain talent while not overdiluting shareholders' equity at different stages of the startup?
Broadly speaking, the size of the option pool depends on your hiring needs and how competitive salaries you can afford to give at different stages of the startup.
In the early days of the startup, you can't match the salary standards of multinational corporations, who are competing for the same talent as you. But this shouldn't limit you from pursuing top talent.
As a startup, you can give benefits to the employees that large corporations can't, such as flexibility of working hours, remote work, better work profile and more say in the decision making. They can be on an entrepreneurial journey—without all the risks it comes with—and give them an opportunity for massive wealth creation.
ESOPs are one such way of wealth creation for employees, especially those who join you early.
Other factors affect the option pool size as well, such as your stage of evolution, funding raised , dilution you are willing to take and efforts you take to communicate the value of stock options to your employees.
How can a large or small ESOP pool affect your growth?
A large employee option pool dilutes your ownership in the company, which may cause issues while raising funds later. Investors would think twice about investing in a startup if the founders only own a small portion of the company. It makes the startup unattractive to investors.
For founders, creating an ESOP pool leads to dilution of ownership. Though you can limit dilution by having a small option pool , keep in mind that no startup can grow without the dedication and belief of early employees. Most employees look to ESOPs as a key decision factor while joining a startup. Therefore, a small option pool is a barrier to your hiring requirements.
Often, working in a startup requires going beyond the job description. This is only possible if employees are adequately incentivised. If the employees don't have skin in the game, they may not be motivated to give their best.
ESOP pool representation in cap table: Note that stock options in the ESOP pool are not shares until they are exercised by the employees holding them.
So, they are reflected in the cap table as a line item below the total number of shares issued and further subdivided as allocated and unallocated. Those employees who have exercised their option are a part of the cap table.
Let's see how pool size varies at different stages of a startup.
Often founders go for fundraising after reaching their next milestone. So, it becomes crucial to think ahead about your hiring needs during the period and create a large enough pool to distribute amongst the hires.
The main goal of the seed-stage startups is to build a product and test its feasibility in the market. Here, the majority of hiring is done for product development.
As you have limited cash, you cannot afford to give competitive salaries to these hires. Hence, ESOPs are used to attract and retain talent to compensate for lower cash-based salaries. The employees who join you at the initial stage take a higher risk and expect to be rewarded accordingly.
Factors that you should consider while giving ESOP to any hire are the value that hires bring, how much salary cut and the risk he/she is taking working with you.
10-15% ESOP pool size is considered good as per market standard but keep in mind that you can keep a smaller or bigger pool depending on your hiring needs. 11. It is recommended not to create a larger pool upfront as new investors ask to expand the ESOP pool while putting their money in, further diluting your equity.
The pool size also depends on the employee preference. Those with an entrepreneurial mindset would want to take higher stock options and may be ready for a salary cut.
Those who are conservative may not be ready to take a salary cut but want ESOPs on top of their salary.
You may want to reward each employee who joins you at this stage by giving them a larger number of options from the pool than the employees who join you at later stages.
For founders, it helps them decide if the employees are the right fit for the startup and can shape their hiring decisions. If an employee is willing to take a long term vision along with the founder, he/she should be willing to take a part of compensation as ESOPs.
At this stage, you may want to hire mid-seniority people who can take leadership roles in the future. These people should be good at building and testing hypotheses, ready to fail, iterate and learn, and be good at communications.
The employees you may want to hire should be self-motivated, well organised and multitaskers.
Some of the key hires at this stage are those who can help you with:
Apart from these, you may also want a board of advisors. These are senior professionals, or maybe founders themselves, but they won't work for you full time.
Their experience can be beneficial during the early stages of the startup and prevent you from making mistakes that could prove to be costly in the future.
Generally, startups have already developed the product and tested it with beta customers by the time they reach this stage.
At series A and B, startups aim to acquire more customers, and the critical hiring needs are for building a foundation for scaling. You may want to hire growth marketers and sales specialists. As your startup is generating some revenue at this stage and you may have raised a few rounds of funding - Therefore you can afford to give better salaries.
Also, the company is more established, and those who are joining are taking comparatively lower risks than the early-stage. Hence, you can give lesser ESOPs to the talents who are joining at this stage. 7-10% equity as an ESOP pool at this stage is market standard. 8. During the creation of a new pool, generally, all the existing investors dilute their equity.
Founders can negotiate a low top-up to the ESOP pool to the new investors if the pool created previously is not exhausted/have some options left to be distributed.
Even if you have unallocated options from the previously created pool, the new investors may ask you to create a fresh option pool. So, you may end up overdiluting your and other existing shareholders' ownership.
Founders can push back against this by showing that the pool size proposed by them is enough for the hiring needs. And give security to the new investors by giving them anti-dilution provisions. This means if the proposed pool is found to be insufficient, then the remaining pool would only come from the existing shareholders, not the new investors.
ESOPs at this stage may not be given to every new hire. It's mainly given to key hires or to incentivise performance.
Some key hires at this stage may be:
Though the initial sales may be done by founders, this may be the time to transition from founder-led sales towards sales led by growth professionals.
These people have years of experience selling the product, thus taking the startup to the next level. They increase your chances of becoming the market leader in the industry.
By growth startups, we mean the startup at series C, D, E… stages. At these stages, startups have substantial cash flows, and there is a product-market fit.
Startups are relatively stable, and risk is less than the earlier stages, as the failure rates are less.
According to a report by Trifecta Capital, more than 50% of Series A startups have an ESOP pool larger than 7.5% compared to ~30% of growth-stage startups.
At this stage, startups are well-known. So, it's relatively easier to attract talent as people want to join these startups.
As you can afford to give competitive salaries, the options should be offered based on performance and used as a tool to bring the best out of the employees.
To provide liquidity to ESOPs holders, recently, startups have started buying back ESOPs at these stages. That helps in employee wealth creation, and they can reap out the benefit for their contributions.
So, they need not wait years for the startup to take an exit: go public or M&A.
At this stage, the ESOP pool size shrinks to 5% to 7% or lower as the company's valuation is high.
So, options should be given selectively to those who contribute and add value; options are mostly used to incentivise growth.
Anirudh Rastogi, the founder of Ikigai Law, suggests that founders should only offer ESOPs to their most valuable employees. If an employee has innovative ideas and is disciplined in their approach, prioritise them for the ESOP grant.
You can hire experts and managers who can optimise the company's operations, set up processes and cut costs. These hires can be rewarded with ESOPs based on their performance and how much cost they save for the company.
Recently, Paytm increased its ESOP pool size by more than double from 24.09 million equity options to 61.09 million options before launching its IPO to reward the employees. After the pool expansion, the total size of its ESOP pool was about 10% of the total equity.
Creating the ESOP pool is just a part of the hiring strategy. You need to distribute the ESOP to the right employees in the right amount and communicate the value of the same for them to be an effective tool for employee motivation and retention.
If employees don't value your ESOPs, there is no point in giving your equity away as it won't do its job.
ESOPs can be entirely new for certain employees. Many of them may prefer cash bonuses which they can immediately use for their expenses.
In contrast, ESOPs have time-bound conditions attached to them. Hence, it is essential to educate your employees on the real efficacy and wealth creation potential of the ESOPs in the long run. You (or the CHRO or CFO) can have a 1-on-1 discussion with the employees and clarify their doubts.
For founders, creating an option pool on Qapita has benefits, such as ease of administration and granting ESOPs. Otherwise, they would have to go through the entire process each time they want to give stock options to any employee.
Once you have set up your ESOP pool, you need to ensure that you manage it well. If you don't, your ESOP pool can get exhausted, and you may have to dilute your shares further.
Traditionally, the ESOPs were given as physical grant letters, which employees used to forget once given. But now, there are solutions in the market that solve this problem.
Qapita, an ESOP management tool, helps startups digitise the entire ESOP setup, administration and granting process.
It saves time and helps communicate the value of ESOPs to employees. You can share a monthly equity slip, just like a salary slip that shows the value of their vested and exercised options.