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An Intro to Employee Stock Option Plans for Startup Founders

A couple of notes on Employee Stock Option Plans (ESOP):

🗜️ESOPs are as much for your benefit as your VC: There are many ways VCs can hurt startups — this isn’t one of them

🍤 Startups shouldn’t skimp on ESOPs: This is the capital you use to recruit talent

Let me expand:

I recently wrote about how founders should talk about stock options with employees:

Now I want to address how VCs think about Employee Stock Option Plans, why they sometimes (and legitimately) frustrate founders, and how to think of them productively.

It’s important to acknowledge why ESOPs are so controversial. They typically represent significant dilution on top of whatever valuation the founders negotiated. Procedurally, they are often one of the final economic points negotiated which enhances the annoyance.

For VCs they’re largely just another item on a closing checklist. For founders — who, at the seed stage, may never have considered the dilution before — ESOPs often feel like one of those “dirty tricks” VCs are infamous for.

Founders typically try and negotiate the ESOP down, often dramatically, from a standard 10–12% at seed, down to 5–8%. Or they ask to base the option pool on the post-money valuation instead of the pre (which is non-standard).

All of this brinksmanship is highly understandable in the short-term but can damage value in the long-term. Why?

The ESOP is how you attract the key employees who are going to help you build the company. Often founders think they have the right team in place already and don’t need as large a pool. I assure you, after watching 200 startups grow, this is never true. Especially at seed.

You’re very likely going to make dramatic product changes, alter your business model, perhaps shift markets. Your small team might be world-class for your current goals, but it’s likely those goals will change — in the next 18–24 months & great talent will be essential.

You also want to be prepared to snap up talent. Perhaps you’re able to convince a legendary VP of sales that your company is the next rocket ship. She buys into your vision and wants to leverage her contact list on your behalf, but also wants at least 3% of the company.

In a scenario where you have a 5% option pool, that’s going to pose a major problem. You’re going to talk to your investors about further diluting them between financings, which can be an uphill battle since expectations were set otherwise.

I think the best practice is to build a realistic bottom-up equity plan for your expected hires during this financing period (before you raise your A) and round up to make sure there is room to maneuver if you need more than you think (which is somewhat inevitable).

You might think it’s self-serving for a VC to advocate for a larger ESOP, but we aren’t life-cycle investors, so we dilute alongside founders. This is the same guidance we give our founders when our equity is being diluted by the ESOP.

In closing, remember that the employee stock option pool is the key tool at your disposal to recruit and retain the kind of talent that will be required to make your startup a success. Be careful not to be penny-wise and ESOP foolish.

Managing Partner Eric Paley recently shared this as a tweetstorm. We collected the tweets as a post for your convenience.

Follow us on Twitter @fcollective.

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