The costs to establish and operate an ESOP can be significant. Whether owners leave slowly (by selling gradually and remaining involved) or quickly (by cashing out and leaving), they can be exposed to risk, since the company's future cash flow will be used to repay any bank loan to the ESOP.
Steps to Setting Up an ESOP
- (1) Determine Whether Other Owners Are Amenable.
- (2) Conduct a Feasibility Study.
- (3) Conduct a Valuation.
- (4) Hire an ESOP Attorney.
- (5) Obtain Funding for the Plan.
- (6) Establish a Process to Operate the Plan.
The bottom line is that instead of owning 75% of the company, the
founders will end up owning 60% of the company, and the investors 25%. For the
founders, the $1.3 million financing was not 25%
dilutive but 40%
dilutive.
Option pool.
| Series A |
|---|
| Injected capital | $1,300,000 |
| Post-money valuation | $5,300,000 |
| Dilution | 25% |
As a rule of thumb a non-founder CEO joining an early stage startup (that has been running less than a year) would receive 7-10% equity. Other C-level execs would receive 1-5% equity that vests over time (usually 4 years).
ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them, putting cash in to buy existing company shares, or borrowing money through the entity to buy company shares. ESOPs are used by companies of all sizes including a number of large publicly traded corporations.
Stock dilution occurs when a company issues new stock, and the current shareholders experience a lessening of their ownership percentage in the enterprise. When a company issues more shares, stockholders own a diluted percentage of the company, and the value of each individual share decreases.
Outlined in a company's funding and investment agreements, the most common form of anti-dilution provision protects convertible stock or other convertible securities in the company, by mandating adjustments to the conversion if more shares are offered.
In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan.
A rising share count can dilute the value of your shares. Many assume that the issuance of more shares is unfailingly bad news, causing dilution. It actually can be not so bad, if the funds raised by selling the new shares are spent in a very productive way.
Because of the dilution that warrants represent, the value of that call needs to be divided by (1 + q) where q is the ratio of warrants to outstanding shares, assuming each warrant is worth one share. The formula gives the theoretical value of an option.
Current shareholders sometimes view dilution as negative because it reduces their voting power. Diluted earnings per share is a way to calculate the value of a share after convertible securities have been executed.
Stock dilution is legal because, in theory, the issuance of new shares shouldn't affect actual shareholder value. In practice, however, the issuance of new shares can destroy shareholder value. This normally happens when the issuing company: Sells the newly issued shares at an undervalued price.
1 : the action of diluting : the state of being diluted. 2 : something (such as a solution) that is diluted. 3 : a lessening of real value (as of equity) by a decrease in relative worth specifically : a decrease of per share value of common stock by an increase in the total number of shares.
So here are 4 ways to raise funding for your startup or small business without the headache that dilution gives you.
- 1 – Bootstrap. This is always the facetious answer.
- 2 – Loans. I consider the topic of loans as twofold: direct and indirect.
- 3 – Grants (Government)
- 4 – Grants (Foundations)
- Conclusion.
Fully diluted shares are the total number of common shares of a company that will be outstanding and available to trade on the open market after all possible sources of conversion, such as convertible bonds and employee stock options, are exercised.
Definition: Equity dilution refers to the cut down in the stock holding of shareholders in relative terms of a particular company, usually a startup, whenever an offering for new shares is made whether through an IPO, FPO or private equity.
Dilution refers to the process of adding additional solvent to a solution to decrease its concentration. This process keeps the amount of solute constant, but increases the total amount of solution, thereby decreasing its final concentration.
If you quit or get fired before your Esops get vested, you lose your money. Even the number of Esops that you vest per year during the vesting period often follows a schedule that does not favour the employee. You may be able to monetise your Esops, if your company gets acquired.
ESOPs would be taxed as perquisite, the value of which would be (on date of allotment) = (FMV per share – Exercise price per share) x number of shares allotted. The amount calculated above as perquisite value of ESOP i.e. Rs. 4,00,000 shall form part of X's salary and be taxable in the year of allotment of such shares.
So, in essence, ESOPs should be structured around three things — the stage of the startup, the contribution of the employee, and his/her compensation package, while keeping an eye on the equity pool.
Equity for first employees and founding team:At an early stage (up to 10 employees) the reports suggest you might expect to give up to 1 % of the total company equity per employee.
A third method is to note that early-stage employees generally get between 1 and 5% as much equity as a founder (early stage employees will get usually . 5-1% and founders, at the time they are giving out those large equity stakes, will have 20-50%).
Terms like 'seed round' and 'Series A' are less clear than they used to be, but in general, I recommend companies think about selling 10-15% in a seed round and 15-25% in their A round (and about 7% if they go through an accelerator).
Focus On Structure. If you want to lessen dilution, structure your business well. Only take on investors whose resumes add to the quality of your venture. Decide against numerous investors, just because they will pay more than they should for a small stake in your business.
Dilution in startups is the decrease in ownership for existing shareholders that occurs when a company issues new shares. So dilution decreases your ownership stake in your startup. But many things other than issuing new stock can also decrease a shareholder's economic ownership.
When the founders have agreed on the ownership percentages (i.e. percentage of common shares issued), they can then determine how many shares in total to issue. This number is usually kept small at the beginning, e.g. 100 or 1000. This number can be "split" (multiplied by 2, 10 or whatever) as required.
Dilution is the addition of solvent, which decreases the concentration of the solute in the solution. Concentration is the removal of solvent, which increases the concentration of the solute in the solution.
Formula: New Investment * total post investment shares outstanding/shares issued for new investment. “ Option pools can also be formed by Restricted Stock Units, but whichever one you use, they are generally still called 'Option Pools'.
