ESOP 101: Role in Stock Option Pool and Equity Financing Part 9
By Joanne Hue, published: 2023-04-15
ESOP or Employee Stock Option Plan allows companies to incentivize competent employees by providing them with an ownership option in the company. Equity financing in businesses is used to collect funds in exchange for shares in the company. As ESOP is a form of equity finance, companies set a share option pool to determine which individuals can hold the option to obtain stocks in the business. The size of the option pool changes depending on the stage of the company’s growth.
The Role of ESOP in Stock Option Pool
A stock option pool is a collection of shares reserved for employees of a private company. It is used to incentivize talented and competent individuals to work for a company for a long period. If the employees assist the company to become public, they are granted stocks for their contributions to the company. Usually, the employee who is a part of the startup receives a larger portion of the option pool than the employee who participates later.
In the subsequent funding rounds, the initial size of the option pool decreases. This is a result of ownership demands from the investors. Angel investors and venture capitalists tend to seek equity in the company in return for their investments. Eventually, the creation of an option pool dilutes the shares of the founders.
The stages of growth in an ESOP option pool
The employee stock option Plan’s option pool experiences the following stages of growth:
- Early Stage – Aggressive ESOP Play
The early stages comprise seed and angel rounds. During this stage, the company has less liquidity. If such companies are seeking to hire C-suite executives and employees with expertise that is critical to their business, they may not be able to afford these individuals. Employee Stock Option Plans come into play in these circumstances. Companies can hire people by offering them the option to hold ownership of the company. When funders offer ESOPs at this stage, they ought to do so aggressively as they do not have a cash component to offer these individuals. In this stage, attracting employees is the primary objective. Therefore, ESOP grants in this stage are often heavy with flexible policies.
- Growth Stage – Aggressive cash play
With the expansion of the business, founders should shift their priorities and make ESOP grants extremely restrictive. As the company grows, it has higher liquidity and should be able to match the cash expectations. In this stage, ESOP grants should be reduced and the cash components should increase. In the growth phase, companies should be able to provide the payment demands and the ESOP should only serve the function of retaining individuals that are highly valuable to the business. These individuals may be employees with unique expertise, employees that are out-performing or employees that bring great utility through their work in the company. Some employees are significant to the operation of the business, and their skill set may be sought after by other competing firms. Allocating equity to such employees can incentivize them to stay in the company and work for it for a longer period. It also discourages them from sharing crucial information when they exit the company. As the valuation of the company tends to be high in this stage, founders should be careful in allocating stock options only when it is highly required.
- Maturity Stage with balance in ESOP grants and cash play
When startups reach the mature stage, their option pool should be balanced with the cash component. In this stage companies generally seek to maintain their value in a stable way, so they should focus on performance-based ESOP grants. In the mature stage companies already have the infrastructure that is required for a sustainable business and can afford competent individuals through cash payment. Likewise, the business is no longer in the developmental stage and aims on maintaining its revenue generation with a steady increase in productivity. In this stage, the needs of the shareholders are the focal point of the company and the administration seeks to maintain premium performance in their employees. ESOP grant is balanced with cash play when the business reaches maturity. Since the Fair Market Value or FMV of stocks of a company in a matured stage is high, founders should seek to balance the reward they present for an employee’s performance.
Role of ESOP in Equity Financing
When a company raises money by either selling its shares to existing shareholders or third-party purchasers, it is known as Equity Financing. Equity Financing does not mean that the new shareholder has absolute control over the company. Most of the time, equity financing is done through the transaction of minority shares.
ESOP financing is a type of equity financing it provides employees with the option to own shares in the company they work for. One of the fundamental characteristics of ESOP financing is the fact that it allows a company to decrease the cost of burrowing in cash while increasing its total cost. This is because principal payments and interest payments are deductible when paying the ESOP loan. Financing an ESOP includes the transfer of shares from the employer to the option plan.
To set an ESOP money is burrowed and an agreed number of shares from the company is bought. These stocks are placed in the suspense account and can be used as collateral for loan purposes. With the repayment of the loan, shares in the suspense account are released and allocated to the employee accounts. This is done on a pro-rata basis.
Basic leveraged stocks allow three distinct structures. In the first structure, the ESOP provides the note to the lender. This note is accompanied by the employer’s guarantee. In the second structure, the loan can be made directly to the company and the company can create a “substantially similar” loan for the ESOP. This provides assurance to lenders who are not comfortable lending their money to the ESOPs. In the third alternative, the company creates the loan. However, in place of providing that loan for the ESOP, the company creates a non-leveraged option plan. This is followed by, the contribution of shares to the scheme instead of years of loan repayment. This structure allows the company to retain benefits from cash flow in ESOP financing.
A company’s decision to grant share option plans to its employees is highly influenced by the stage it is present in. Startups with low liquidity tend to give out more share options where as growing and mature businesses tend to balance the provision of options with cash components. ESOP is a form of equity financing that may or may not be leveraged.
You may also like:
- ESOP 101: Introduction to Employee Share Option Plans (Part 1 of 10)
- ESOP 101: Understanding Vesting, Exercise, and Expiration Terms Part-2
- ESOP 101: The Process to Set Up an Employee Share Option Scheme Part 3
- ESOP 101: Communicating and Administering an ESOP – Part 4
- ESOP 101: Tax Implications and Accounting of an ESOP Part 5
- ESOP Benefits for Employees, Business, and Shareholders (Part 6 of 10)
- ESOP 101: Option Scheme Drawback and Maximizing Value Part 7
- ESOP 101: Risk and Compliance with Stock Option Scheme Part 8