PS#094: Employee Stock Ownership Plans (ESOP) – Structuring (Part 3)

In the ​last issue​, we talked about ESOP and the impact of dilution over the life of a startup

Today, we’re going to look at how investors think about ESOP, especially when it comes to structuring financing rounds.

We’ll discuss the following…

• Stakeholder alignment

• Attracting & retaining talent

• Protecting against future dilution

Alright, let’s dive in.

Stakeholder alignment.

Great investors think of financing rounds as an opportunity to align all of the stakeholders on one great, big vision, which is…

Building a successful company (however that may be defined).

Now, to achieve that alignment, investors need to consider the following parties…

• Founders

• Employees

• Existing investors

• Future investors

As the startups grow, alignment becomes more and more complicated. Each of these ownership classes have different expectations, priorities, incentives, etc.

Without going into all of the excruciating details (I’ll save that for a future issue), the lead investor (or the one structuring the round) needs to try to make the opportunity attractive for each class of owner to keep all parties pulling in the same direction.

It’s not easy and doesn’t always work out.

However, when it comes to the ESOP, employee incentives, and overall dilution, there are some good guidelines that have been established.

Attracting & retaining talent.

First and foremost, investors want to make sure there is enough ESOP available for founders to attract and retain the talent that they need to achieve the goal.

In diligence, investors will go in-depth on the talent and hiring needs of the startup for this next stage (as well as future stages). While founders and investors may not have all the answers, thinking this through is critically important. As a company scales, attracting and retaining talent becomes a top priority (if it hasn’t been already).

So, in structuring the financing, investors will want to know what exactly do we think we need to retain and attract the talent needed to accomplish the next set of milestones.

In most cases, the lead investor will want to be more conservative, leaning towards a larger ESOP with some buffer. This helps in two ways…

1. It lowers the price per share

2. It makes sure the company has enough equity to attract and retain talent

Now, founders will likely want to be more exact in their approach to equity needs and hiring plans. From their perspective, a more exact ESOP (with less buffer) will…

1. Raise the price per share

2. Allow any increases (in between rounds) to the ESOP (and corresponding dilution) to be shared across all investors, including the lead investor (pending approval)

This leads to a bit of negotiation between the lead investor and the founders.

Protecting against future dilution.

Let’s divide this topic into two categories: investors and founders.

Investors

Most (if not all) investors would rather make the option pool as big as possible as early as possible and not worry about it ever again.

We call this “set it and forget it”.

Of course, as I outlined in the last section, this is usually a negotiation that gets to a more exact answer around the startups perceived needs.

Unlike employees (and even founders to some extent), investors have rights and protections to fight against future dilution, including…

• Anti-dilution

• Participation (pro rata) rights

• Board governance & approvals

These protections, along with reserve capital for future investments, allows investors to protect their positions against dilution (and even increase it in some situations).

This means, as I highlighted at the beginning, that most investors will want to make sure there is ample ESOP available for any employee hires or retainment needs.

Founders

For founders, the main lever is that they sit at the negotiating table.

They are significant owners of the asset in question (i.e., the startup) and can negotiate a situation that will be beneficial to them.

In particular, founders can negotiate opportunities to increase their ownership position. If a founder’s ownership becomes too diluted over time, the founder (and the investors to some extent) will want to make sure that there is enough equity value for them to continue driving this forward.

Remember, it’s about value, not percentage. The outcome of the equity needs to be worth the impossible job that most founders are taking on in building a venture-backed startup.

So, how do they do this?

When negotiating a financing, the investors/founders can create opportunities for the founders to earn more equity. This could be incentive or milestone based, or it can be done with traditional vesting schedules. Logistically, they will carve out some portion of the ESOP for the founders to reach the appropriate ownership levels.

A quick side note, this can also be a strategy for investors to keep valuations lower. By carving out some of the ESOP to “top up” founders, the founders may be more open to a lower valuation.

At this point, what should be clear is that founders and investors have avenues to handle future dilution (although to varying degrees).

Employees are more or less along for the ride. It’s up to the founders, investors, and leaders of the company to advocate on behalf of employees to make sure that there is full alignment.

As I mentioned earlier, this is complicated and it sure isn’t easy.

It requires key stakeholders to be thoughtful and always thinking…

What will lead to building a successful business?