The ESOP Complex – Part I

In the first of a 3-part series, the author discusses the criteria for deciding on the quantum of ESOP pool and weighs in on the merits on which to allot the stock options to employees.

With the COVID crisis expected to devalue the stock valuations of some large companies, questions are being raised about the relevance and efficacy of ESOPs. People have different impressions of ESOPs. Employees at times think it gives them a ticket to the million dollar club; while employers believe it can be used for attracting and retaining high quality talent. But everyone needs to know that the most important term in ESOP is “Option”. 

Founders struggle with the right framework on ESOPs. In a 3-part series, I will address some of the key questions that are associated with ESOPs. To be clear, this is not ESOPs for dummies.

How much of the company should be set aside for ESOP pool

For this question (like the subsequent ones) there is no one perfect answer. However if you are starting with two co-founders, I recommend setting aside 15-20% of the company for ESOPs before your first institutional fundraise.

If you are a sole founder, then 20-25% is more appropriate. Similarly if you have more than two co-founders, you can reduce the ESOP pool proportionately. You would be surprised how quickly the ESOP pool gets exhausted. The first venture investors are likely to enforce setting aside a large option pool.

Who should be allotted ESOPs?

If founders get this right, all other issues become less significant. There are two schools of thought. One is to offer options to as many people as you can (“distribute wealth”). The second one is to offer to the “right” set of people. Till the time the company is a unicorn, I recommend following the second approach. At Fisdom we use the following framework:

Risk-Impact-Effort. We allot options to employees who score very high on each of these but in decreasing order of significance. Let me explain.

Risk is the first factor, which applies to employees who have assumed risks to join you. Risk taking could be: joining very early when the foundations were weak (e.g. before an institutional fundraise) or someone taking a pay cut to join at any stage.

In both cases, be generous with options -- 1.5-2x of the market salary minus the cash compensation offered. If you are hiring someone at a market clearing price (through a search, etc.), I do not recommend offering options upfront when the employee joins at any stage, even if he has a track record.

No interview process can help you judge fully whether the candidate will be a good fit; performance in one context does not guarantee the same in another context. Make every employee earn their options but when you give, give generously. 

Offering equity to employees should be the result of the employees taking ownership and not the cause.

Impact is the second factor.

I recommend allotting options to employees who have made an impact on the business already or you believe will have a positive long-term impact on the business. But this view should be based on the actual working experience with the person and not on interviews.

If the employee is being paid market salary, then a 2x-3x multiple of his compensation is a good benchmark for the value of options to be granted.

Effort is the last factor. In every company there are people who are just amazing man Fridays or do-gooders who keep up the cheer of the office. It is worthwhile rewarding those employees.

While granting of options can be looked at independently based on these factors, in reality, one has to look at the combination of these. In such situations, the framework is best used at an intellectual level. But if you want to quantify this, the weights for Risk - Impact - Effort would be 7-10-3. Founders can set a threshold for qualifying for grant of options (Recommended threshold -- 12)

In Part II, I will cover the aspects of a good ESOP policy.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)