ESOPs get converted into Equity shares and result in dilution of existing shareholders’ ownership. In this context, how much Equity should the Promoters keep aside is a key decision while implementing any ESOP Plan. The decision needs to be evaluated keeping in mind viewpoints of both the stakeholders viz. promoters (existing shareholders) and the employees. The third stakeholder, the Regulator is silent on this subject and has left it to the existing shareholders to decide the ESOP pool.
From the shareholders’ point of view the first call is about whether to accept employees as co-owners and partners in sharing the wealth created. If the answer is no, then the alternative is to look at Cash settled Options (also known as Shadow or Phantom options). However, if the answer is yes, the decision on extent of dilution depends on:
- Number of employees to be covered under the Plan, more employees would need more shares hence higher dilution
- Objectives of the Plan. If the aim is to make ESOPs a part of the compensation (performance reward), the Plan will have to run for a longer period, requiring bigger equity pool. If the intention is to help retain the core team, the pool will have to be adequate enough to be a deterrent. Usually potential income that ESOPs generate over a period is in multiples of the fixed Cash compensation. If the objective is to promote broader employee ownership the Plan would need bigger equity allocation.
- Term of the Plan. If the intent is to make it one-time event (e.g. entry of a new Investor, IPO of the Company, silver jubilee of the company), equity pool needed would be much smaller.
- Existing equity base. This is in turn depends on the nature of business. For instance, an Infrastructure company or a NBFC needs to have a large capital base from inception and would need lower pool (in terms of %) as against a Software or an Internet start up for whom a smaller % of equity would suffice given their higher valuations from initial stages.
- Exercise price. If options are issued at a discount to the fair market value, less shares are needed to give the same amount of benefit, thereby leading to lower dilution.
Does having a smaller pool mean you should or can give less to employees? Not necessarily. It is possible to give more benefit with lesser shares by tweaking the terms, type of instrument, etc. That’s a topic in itself.
Any ESOP plan to be successful and effective needs to be sustained for a longer period because by definition, ESOP is a long-term incentive. The pool size should be adequate enough to suffice for allocation over a 4-5 years. In case of listed companies, dilution is calculated based on the Outstanding number of Options. Exercised Options converted into shares are not considered as a part of dilution. At the cost of generalizing, the thumb rule is that dilutions are in the range of 2% – 5% in case of large established listed companies, whereas the same in case of unlisted early stage companies it is between 10% – 12%.
Any equity-based instrument is a costly instrument for the employer, its judicious use is essential. The Equity pool allocation has to be done bearing this in mind.