13 Apr Employee Stock Plan and Its Impact on Subsequent Share Issuances

As a business owner planning and working with share capital, it’s important to know your way around a share capital table (cap table). A cap table tracks shareholdings in terms of number of shares held and the resulting ownership percentage. It is used to record and plan a company’s existing and anticipated share structure and ownership as it grows. It helps to analyze the possible consequences of your plans so that you can avoid costly mistakes.

Previously, I looked at the consequences of seeing shares as a static pool rather than a constantly increasing pool.This common misconception amongst business founders can lead to anything from confusion to the breakdown of relationships with investors.

However, this isn’t the only dilution issue founders need to model carefully.

When an employee stock plan (ESOP) is created, a company allocates a certain number of shares (typically 10% to 15% of the outstanding issued shares) into the plan and reserves them for eventual issuance under the plan. Employees are then granted options to purchase some of the reserved shares. The options may be granted fully vested, may vest over time, or upon achievement of a milestone. Below is a standard 15% ESOP reflected in a cap table. Note that all of the shares allocated to the ESOP are typically shown, even if some or all of the options have not yet been granted. This additional detail may be reflected via a note, or two lines on the cap table, one showing shares allocated to granted options, the other showing shares still available for granting.

ESOP has big ownership implications

An ESOP (or other significant amounts of convertible securities) can have big ownership implications when investors become involved. Sophisticated investors typically frame their valuations in terms of being post-money and ‘fully diluted.’ Fully diluted means including all issued shares, and all shares allocated to unexercised stock options and other convertible securities, and in some cases, assuming that the ESOP is fully allocated – whether or not that is the case.

In the original example of each founder holding 250,000 shares, a 15% ESOP means the investor is issued 503,000 to own 30% of the company post-money and fully diluted.

There are many different options investors can pursue in relation to an ESOP depending upon their leverage. Note in the preceding example that the ESOP was reduced from 15% to 10.5% by the investor’s shares. If there is a question as to whether the ESOP is large enough, the investor may request that the company adjust the ESOP pre-closing so that it is equal to 15% of its issued share capital post-closing. This is the most beneficial arrangement for the investor, and in our example, will result in the investor being issued 545,000 shares for its 30% ownership stake.

Using a cap table and retaining a lawyer to model the different scenarios is the only way to negotiate and understand the ownership implications of different proposals.