Equity compensation is one of the fundamental building blocks of starting up, especially because it speaks volumes about a founder's vision for the company. When you set up equity compensation early on, you are essentially communicating your belief in the future success of your business.
In our ESOP101 series, we have been working to educate and improve the knowledge surrounding equity compensation and its myriad forms. For example, in the last blog, Regulatory Compliances for Equity Compensation in India, we understood the nuances of legally getting various equity compensations, including ESOPs, off the ground.
Today, we will tackle a vital equity compensation pillar– structuring the option pool. This pool's initial carving must be moderate to avoid excessive dilution of ownership among shareholders. Therefore, if the pool is too small, the business will be compelled to dilute its equity pool with each employee grant.
To begin with, an option pool allows businesses to reserve equity for their employees.Consider it a portion of the company's total equity set aside for any employees/contractors/advisors you may want to incentivize for their contributions, be it immediately or 2 or 5 or 10 years later. Hence, future growth is to be kept in mind
Even though an option pool can be increased in the future, it will require agreement from all the shareholders of the company, which is a process that can cause delays. Hence, a well-thought-through and structured options pool allows a business to issue options without requiring additional stakeholder involvement later.
Usually, there is no standard size for an options pool. The company and its shareholders make the decision basis their plans for team expansion in the near future, say 2-4 years. Typically, we have seen an option pool of 7-10% of the company's issued share capital at the time of the initial set-up. Companies tend to increase it up to 20-25% in the growth stage.
Some of the crucial things to keep in mind while structuring this pool are the startup stage, the employee's contribution, and their compensation package while keeping an eye on the equity pool.
The company's growth journey can be divided into three stages: formation, validation, and growth. Each stage corresponds to a different allocation of equity to employees.
During the formation phase, the idea is to provide early employees with a larger share of equity. Then, as the company progresses to the validation phase, the equity allocation is still significant but slightly smaller. Finally, in the growth stage, the equity share for early employees is somewhat reduced compared to the previous stages.
It is important to note that the company needs to incentivize via equity to acquire new talent in the formation or early stage. This is because it doesn't have enough cash to match the talent's market value in cash compensation and, therefore, has to simulate it via equity grants.
But as the business grows, its share value is also inflated. Therefore, with a new hire at a growth stage, a company needs to consider this inflated share price and grant basis the weight this employee brings to the company.
More importantly, in the early stage, a company may grant stock from the pool to employees on their very first day in the company. But as it continues to grow, the options may not be offered to every employee but instead, be selectively offered to some during their bi-annual or annual performance appraisal process as a reward considering the contributions made by the employee and the employee'semployee's willingness to go the extra mile for the company.
Hence, it is imperative to keep the following in mind:
- Have clear objectives for the option pool, which may vary from retaining talent, aligning employee interests with company success, and motivating employees through ownership.
- Have clarity on employees who should get equity, i.e. will the equity granted depend on their tenure, position, impact created or more?
- Guidance on equity grants and vesting schedules from experts depending on the company stage
- Establish processes to enable transparency with employees to help them see the value of their equity regularly, the impact it creates, and the future
We at EquityList have advised over 260 companies through their ESOP pool and scheme creation process. If you have more questions, you can write to us at email@example.com
Stay tuned for the next blog!