PS#093: Employee Stock Ownership Plans (ESOP) – Dilution (Part 2)

In the ​last issue​, we talked about ESOP, how they work, and why they are important.

Today, we’re going to dive into how all of this works over the life of a startup and how companies should think about their employees’ ownership.

We’ll walk through the following…

• Evolution of a startup

• Impact of dilution

• Size & strategy

Without further ado, let’s begin.

Evolution of a startup.

Let’s start by setting the stage a little bit, outlining the typical evolution of a startup.

In today’s day and age, a startup will move through a series of stages (and financing rounds). These typically include pre-seed, seed, Series A, Series B, etc.

Let’s define in more detail what each of these stages means for most startups…

Pre-seed

• Investors: self funded or maybe a friends & family round

• Round size: <$1M

• Development: ideation, MVP, etc.

• Employee needs: usually just starting with founders + contractors

Seed

• Investors: seed stage investors, angels, etc.

• Round size: $1-5M

• Development: MVP, starting to find initial traction

• Employee needs: 0-10, mostly engineering and product hires, and maybe first business person

Series A

• Investors: early-stage VCs

• Round size: $5-15M

• Development: live product, focusing on repeatable GTM efforts

• Employee needs: 10-50, more engineering and product hires, GTM roles, and starting to build out of the executive suite

Series B

• Investors: early- and growth-stage investors

• Round size: $20-50M

• Development: full steam ahead on GTM expansion

• Employee needs: 50-150, more engineering & product, GTM, and G&A hires, while also filling out the executive suite

As indicated by the stages, the startup goes from 100% owned by the founders to being shared across investors and employees. The sharing of ownership helps align all of these different stakeholders to the ultimate mission – building a successful business.

However, with each stage, everything gets more complicated. Balancing hiring, capital needs, and ownership, requires understanding how all of this plays out over time.

Dilution impact.

Most investors and founders are hyper aware of dilution.

When a startup raises additional capital, they are diluting some (if not all) of the existing owners. Founders and investors have levers that can be pulled to protect themselves from too much dilution over the life of a startup.

For investors, their preferred shares will come with rights and protections to help them navigate dilution as the startup grows and takes on more capital. Founders will be at the negotiating table to make sure their equity remains at appropriate levels.

Employees, however, do not (typically) have access to these types of levers.

Employees are left out of the discussions and will depend on the founders/investors making sure there is adequate equity available to maintain alignment and incentives.

So, what does employee’s ownership dilution look like over time?

Here’s a representative example of a very early employee (0-10), who receives a 1% equity stake (common shares) in the startup…

• Seed: 1.00% ownership

• Series A: 0.75% ownership

• Series B: 0.55% ownership

• Series C: 0.45% ownership

• Series D: 0.40% ownership

As we can see from this example, the employee’s ownership percentage decreases over time.

BUT, this is not the whole story…

Percentages are tricky. While they may show ownership as a part of the broader pie, they don’t really tell the story of value (which is the goal at the end of the day).

As the startup raises additional capital, usually the value of the employee’s shares is increasing. An initial $100k of shares may be worth $1M if the startup continues to grow on a rapid trajectory, which (again) is the goal.

Startups can also issue more equity to employees over time, maintaining their ownership percentage or even increasing it.

At the end of the day, that ownership piece (plus the employee’s other compensation) needs to be worth all of the blood, sweat, and tears that they’ll pour into making the company successful.

Size & strategy.

Alright, we’ve walked through the evolution of the startup and what that means for an individual employee’s ownership over the life of the startup.

Now, the question is… How do we handle this?

Great question.

Let’s tackle this from the position of the startup and the founders.

Most startups in the Seed to Series B range are targeting ESOP of 10-20%.

The specific size depends on the specifics of the situation…

• Current stage

• Cultural philosophy

• Talent & hiring needs

• Market equity benchmarks

• Ability to attract top tier talent

• Geographic location & regulations

All of these items play a role in deciding the right ESOP size for the company at a given time. A founder should be looking at all of these different categories when building out the ESOP.

However, in my opinion, all of these categories need one overarching question tying them together…

What will it take to be successful?

Founders need to keep this front and mind throughout this process. It can be easy to get distracted by the complexities of a financing round (i.e., striving for the best valuation, limiting their own dilution, maintaining rights, etc.), but there always needs to be an eye on the long-term goal (and what it takes to achieve it).

As with a lot of startup work, it’s not one-size-fits-all and it very much depends. For example, you might need a company (and culture) that is very equity-driven (due to cash limitations, etc.), or maybe you’ve raised a large round and more cash compensation makes sense.

Founders should really think through their specific situation, leveraging a bottom’s up hiring approach (with the aid of compensation market data) to figure out what type of talent they’ll need to attract to be successful in this next stage.

Again, the success of the business is the goal.

A quick side note, it’s also a good idea to bake in a little bit of buffer in case of market shifts or an opportunity to hire exceptional talent.

However, no matter the situation, there is one clear takeaway from my research and own experiences with startups…

You need to keep your top performers aligned and committed to the overall goal (whatever this may take).

Most startups are intense. They require individuals to really put their heart and soul into their work. In my opinion, it’s hard to do this when you’re not attached to a bigger picture. And for that, I have yet to find a better method than sharing in the ownership (and upside) of achieving that bigger picture.

Alright, next week, we’ll take a look at this from an investor perspective.