Thread by @SuryansMisra

Understanding ESOPs #3

Hi! Today I want to talk about how to decide the size of your ESOP pool.

#startups 🧵

How much of your startup should you allocate for ESOPs?

This is a tricky question and there is no one-size-fits-all answer. It depends on many factors such as your stage, valuation, funding, growth potential, hiring plans, etc.

However, one way to think about it is to make it a function of your employees’ cash compensation.

In other words, how much salary are you willing to trade for ESOPs? For example, if you pay an employee Rs. 10L per annum in cash, you can offer them ESOPs worth Rs. 10L as well.

This way, you can balance the trade-off between cash and equity and also benchmark your ESOP offer against the market rates.

Of course, this is not a fixed formula and you can adjust it based on the role, seniority, performance, etc. of each employee.

To calculate how much ESOP pool you need based on this method, you can follow these steps:

Step 1: Estimate the resource cost How many people do you need between now and the next funding round (or revenue milestone)? What is their average salary? Multiply these numbers to get your total manpower cost.

Step 2: Calculate the post-money value of your startup What is your current valuation (or expected valuation) after raising funds (or generating revenue)? Add this amount to the funds raised (or revenue generated) to get your post-money value.

Step 3: Calculate the ESOP pool percentage Divide your total manpower cost by your post-money value and multiply by 100 to get the percentage of your startup that you need to set aside for ESOPs.

Let’s take an example:

Suppose you are raising Rs. 1 crore at a pre-money valuation of Rs. 4 crore from an angel investor who asks you to create a 10% ESOP pool from pre-money.

Step 1: You need a team of five people with an average salary of Rs. 10L per annum for the next year (your runway). Your total manpower cost is Rs. 50 lakhs.

Step 2: Your post-money value is Rs. 4 crore + Rs. 1 crore = Rs. 5 crore.

Step 3: Your ESOP pool percentage is (Rs.50 lakhs / Rs.5 crore) x100 = 10%.

So in this case, creating a 10% ESOP pool makes sense because it matches with your employee compensation strategy.

But what if you only need three people with an average salary of Rs. 8L per annum?

Then your total manpower cost would be Rs. 24 lakhs and your ESOP pool percentage would be (Rs. 24 lakhs / Rs. 5 crore) x100 = 4%

So in this case, creating a 4.8% ESOP pool would be enough to cover your employee compensation strategy. If you create a 10% ESOP pool as the investor asks, you would be diluting yourself more than necessary.

Of course, this is not the only way to decide your ESOP pool size. You can also consider other factors such as your industry norms, your growth potential, etc. But this method can help you have a rational basis for your decision and negotiate better with investors.

If you have not read the 2nd part, here’s the link:

https://twitter.com/SuryansMisra/status/1636751953194545153?t=SR0707VC2QUbeOSFjQsncA&s=19

That's all for now and yeah...we covered the Basics, key terms and Size of ESOPs pool.
In the coming #4 thread, I'll cover: TAXATION & BUYBACK of ESOPs

I hope this thread was helpful and informative. If you have any questions or feedback, please feel free to reply or DM me. Thanks for reading! 🙏