How ESOP Allocating Order Affects the Outcome

Congratulations. You’ve formed the start-up company, and you’re two founders, each holding 50% of the equity. You randomly decided to allocate 1M shares in the company, You’ve worked for six months, and finally finalized a term-sheet with a VC.

You agreed with the VC on the following terms: The VC will invest $1M, and you agreed that the pre-money valuation will be $4M. Agreeing on pre-money valuation (instead of post-money valuation) makes the math simpler, when you consider leaving the round open for a while, offering other investors to join in. You also agreed, to have a 10% ESOP pool for new employees that the company will hire.

Let’s summarize:

• $4M pre.
• $1M investment
• 10% ESOP pool post round

Now let’s build the CAP (capitalization) table.

Wait a moment… Are there few ways to build it? Let’s see. One way to build it, is to show the pre and post states.

If the pre-money valuation is $4M and the company has 1M shares, that means that the price-per-share (PPS) is $4. That also means that the VC will buy 250k shares.

	Pre		Post
	# Shares	% (Fully Diluted)	# Shares	% (Fully Diluted)
Founder 1	500,000	50%	500,000
Founder 2	500,000	50%	500,000
ESOP			?
VC			250,000

So how many shares do we need to allocate to the ESOP to have a 10% ESOP pool post round?

Let’s do a simple math: X / (1,250,000 + X ) = 0.1

The solution is X = 138,888

So let’s write it:

	Pre		Post
	# Shares	% (Fully Diluted)	# Shares	% (Fully Diluted)
Founder 1	500,000	50%	500,000	36%
Founder 2	500,000	50%	500,000	36%
ESOP			138,888	10%
VC			250,000	18%

Now let’s try another way. The VC says that we should allocate the ESOP pool, prior to their investment.

How many ESOP shares should we allocate? Aha. That’s a bit more complicated. You want the outcome after the round to be 10% (That’s what the VC wants). But the PPS for the VC is going to be calculated not based on the pre-state but rather on the pre-with-esop state.

Let’s denote the number of new ESOP shares as E.

So the PPS is now: PPS = $4M / (1M + E)

Since the VC invest $1M, they should get this number of shares:

VCS = $1M / PPS = $1M / ( $4M / (1M + E))

So, post round, the total number of shares should be 1M + E + VCS:

#Total = 1M + E + $1M / ( $4M / (1M + E))

ESOP percentage should be 10%, so we get:

E / #Total = 0.1

E / (1M + E + $1M / ( $4M / (1M + E))) = 0.1

We have one equation with one variable. That’s solvable.

E = 0.1 * (1M + E + $1M / ( $4M / (1M + E)))

E = 0.1M + 0.1E + $0.1M / ($4M / (1M + E))

0.9E = 100,000 + 0.025 * (1M + E)

0.9E = 100,000 + 25,000 + 0.025E

0.875E = 125,000

E = 142,857

And then VCS = 0.25 * (1,142,857) = 285,714

And total number of shares will be = 1,000,000 + 142,857 + 285,714 = 1,428,571

	Pre		Pre With ESOP		Post
	# Shares	% (Fully Diluted)	# Shares	% (Fully Diluted)	# Shares	% (Fully Diluted)
Founder 1	500,000	50%	500,000	43.75%	500,000	35%
Founder 2	500,000	50%	500,000	43.75%	500,000	35%
ESOP			142,857	12.4%	142,857	10%
VC					285,714	20%

Do you notice the change? The VC gained 2% more, and the founders, combined, lost 2%.

Allegedly, the terms are the same; same pre-money valuation, same investment, same ESOP pool post-round. But the numbers are different.

That happened because the ESOP allocation was done prior to the round, and the PPS was lower (more shares, because of the ESOP).

Be aware.