When is the right time to create ESOP ?

Jun 19, 2021

ESOP is used to reward, attract & retain talent and has become an integral part of the Start-up ecosystem.

ESOP (Employee Stock Ownership Plan) is used to reward, attract & retain talent and has become an integral part of the Start-up ecosystem. 

 “Through ESOP employees can own the shares of the company.”

ESOP is not stock!!! ESOP is a plan which defines how, when & under what circumstances can an employee with ESOP acquire actual shares. 

Since ESOP is not an actual share and if granted has a long vesting period to materialize, this results in deferment of allocation of pool of stocks for the purpose of ESOP.

Premise: Entrepreneurs early in the start-up journey raise investments from Friends, Family, Angel Investors who typically do not lay emphasis on ESOP. Gradually start-ups proceed to raise Institutional Investments where strong emphasis is laid on having allocated pool of stock for ESOP. 

Challenge: Creation of Stock Pool post investment leads to dilution of earlier investors 

The founders and the investors get diluted proportionate for the allocation of the ESOP. 

This practice is criticized by the investor as there is an additional dilution of 0.8% for them and causes delays, pushbacks, multiple rounds of discussions & convincing to be able to proceed with creating the ESOP & raising investment from institutional investors. 

Solution: Entrepreneurs must allocate the pool for stocks for ESOP right from the beginning whether ESOP is granted or not.

Conclusion: Scenario 2 is a preferred choice for founders and Investors.

Founders tend to maintain the same stake in both the scenarios while investors benefit in terms of holding. 

Tip for Entrepreneurs: Under the SHA, usually there is no mentioning of the treatment for unallocated portion of the stock pool allocated to the ESOP. 

Typically, the standard treatment in this case would result in proportionate distribution of benefits accruing to unallocated portion of the stock pool for all on the cap table, while at the time of creation of the pool only the founders had diluted their stake in the company (Scenario 2). 

Thus, to make up for it, the founders can insist on adding a clause in the SHA – “Plough back of unallocated ESOP”. 

Under this clause the unallocated portion of the ESOP will be ploughed back in the founder’s stake, thus all benefits proportionate to such number of unallocated shared will accrue to the founders. 

Illustrations: Assuming no ESOP is allocated and in the event of a trigger event where the stake needs to be calculated on as if converted basis, the following illustration will demonstrate the difference between 

  1. Nothing specified in the SHA 
  2. Specified - Plough back to the founders 

Thus, it is advised that entrepreneurs must be prudent and follow step by step process. Any step missed in between creates challenges at later times (in this case creating the ESOP Pool). 

They should also focus on on-boarding investors, mentors & advisors to help with policy creation, maintaining regulatory hygiene & assisting in legal documentations..!!

Author(s) :
Karan Gupta     
Brijesh Damodaran Nair