ESOP allocation

Introduction

ESOP allocation is a methodology you set up for calculating how much equity you want to share with your employees. To create a functional ESOP, you need to give your current team enough to keep them motivated, but also reserve enough equity for your future hires. This way, your ESOP will be future-proof.

First, you need to know how much you have to give. That's where ESOP pool size comes into play.

What is the ESOP pool and what should be the ESOP pool size?

The ESOP pool is the portion of company equity set aside for employee ownership. Its size depends on the stage of your company. At seed, companies worldwide usually set aside 10%. For US companies, this number usually goes up to 15% at Series A and can go as high as 20–25% by Series D. European companies tend to be more conservative and keep the ESOP pool at 10% throughout their funding journey.

Dilution: what is it and how does it affect the ESOP pool?

When new capital is raised, the value of shares typically increases (unless there's a down round) but the company also issues shares to new investors. This results in dilution — the existing shareholders' ownership percentage goes down. It's common practice to "top up" the ESOP pool with each funding round.

Where to start with ESOP allocation?

ESOP allocation is the distribution of equity in the ESOP pool among individual employees. It's a crucial aspect of your ESOP strategy because it has an impact on employee motivation, retention and overall company culture.

A solid ESOP allocation strategy considers various factors so that the number of assets shared with each employee reflects their contribution to the business. If done right, you can share equity with the right people at the right time.

ESOP allocation methodology

ESOP is a part of the overall compensation package. That's why your employees' annual salary is the starting point for the ESOP allocation exercise.

Follow these steps:

1. Create a list of all people who should participate in your ESOP (don't forget about future hires).
2. Include their annual salary.
3. Select the allocation criteria relevant to your company (see the list below).
4. Give each criterion a weight.
5. Calculate an allocation coefficient for each team member based on the allocation criteria.
6. Multiply the annual salary by the allocation coefficient.
7. Review the resulting grant value (and make adjustments, if needed).

The most common allocation criteria are:

• Seniority: senior, medior, junior
• Technical expertise: technical vs. non-technical
• Potential: low, steady contributor, rising star, superstar
• Department: engineering, sales, marketing, finance, back office etc.
• Tenure: 0–3 years, 3–5 years, 5+ years
• Location: people in different jurisdictions can have different ESOP expectations (e.g. US vs. Europe)
• Incentive: marketing & engineering can be easily motivated with ESOP, sales may prefer commissions

To simplify the ESOP allocation process, we created an ESOP allocation calculator template. Use this template to streamline your decision-making and create a fair allocation matrix.

Final tips and tricks

1. Communicate through value: Show your team how the ESOP value evolves over time. Take advantage of ESOP management platforms like Eldison that help employees track the changes in their ESOP portfolio.
2. Scenario modeling: Show how the ESOP value evolves with each funding round or other milestone relevant to the company. Use it as a communication tool during hiring.
3. Plan for the future: Include the people in your hiring plan, so that your ESOP is really future-proof.
4. Create a buffer: Account for uncertainties and changes in your hiring plan by including a buffer in your ESOP pool. A buffer of 1–2% can do a lot in terms of flexibility.
5. Consider top-ups: The road to exit can be long. Consider whether you want to give additional grants to your team in the future (the so-called top-ups).
6. Be transparent: Clearly communicate how your team can earn additional ESOP grants and what factors impact the ESOP value.

Conclusion

• Fix your ESOP pool size. The standard ESOP pool size at seed is 10% globally.
• ESOP allocation is typically based on an employee's annual salary, weighted by criteria like seniority, tenure or individual contribution.
• Use our free ESOP calculator to get started.
• Put aside enough equity for your future hires. Follow your hiring plan or simply include a buffer.
• Communicate the ESOP value and how it's projected to evolve on the regular.
• Consider ESOP pool top-ups to keep your team motivated and engaged.
• Whatever you do, be transparent with your team.