When negotiating with investors, many companies and founders are focused on maximizing their valuation – which is understandable: assuming the amount of the investment is set, the higher the valuation of the company, the lower the percentage of the company the investor will hold after the investment.
One issue that is often overlooked by companies and their founders when negotiating with investors is the percentage of the company that will be reserved for the “Unallocated ESOP”.
On a company’s cap table, there are usually two rows that show the status of the company’s options – the first is “Allocated ESOP”, or a similar term, which shows the number of options that the company has granted, allocated or promised to others and remain outstanding. The second is “Unallocated ESOP”, or a similar term, which shows the number of options a company has available for granting (but yet to be granted, allocated or promised) to its employees, consultants, directors, etc. If at any time options that are allocated become unallocated – for example, when an employee leaves the company without all of his or her options vesting – then the number of options that become unallocated move from the “Allocated ESOP” row of the cap table to the “Unallocated ESOP” row.
However, when examining the “Unallocated ESOP” row of the cap table more carefully, one comes to the conclusion that this is really just a “made-up” row, the sole purpose of which is to make sure the investor is not diluted by future option grants.
Let me explain. When a company has a reserve of options available for granting and options are actually granted, numbers shift from one row of the cap table to another – and the “fully diluted” holdings of all shareholders remain the same (i.e., no one is diluted). On the other hand, if a company wishes to grant options but does not have a reserve of options (whether it never had one or has fully utilized it), such granting of options increases the number of allocated options, and all shareholders are diluted. Reserving an “Unallocated ESOP” pool ensures that there are not dilutive surprises when options are actually granted (to the extent of such pool, of course).
As a general rule, before an investor invests in a company, the investor requires that a certain percentage of the company be set aside for future grants of options. This number is almost always reflected in terms of a post investment percentage; however, it is taken into consideration when calculating the pre-investment price per share. For example, if it is agreed that an investor will hold 20% of the company following the investment, then many people take that to mean that the stake holders of the company that held 100% of the company before the investment are diluted down to 80% and the investors hold the remaining 20%. This is not the case when there is also an unallocated option reserve. If an investor also requires there to be a 15% unallocated reserve, then the previous stakeholders are diluted down from 100% to 65% (instead of 80%), the investor maintains its 20%, and the new unallocated reserve is 15%. If the unallocated reserve is created after the investment, then the percentages would be previous stake holders – 68%, investors – 17% and the unallocated reserve – 15%.
From this we can see that the higher the percentage of the post closing unallocated reserve, the more the previous stake holders are diluted. The rationale behind having a reserve is that the investor does not want to be diluted by the options the company will be granting in the “future”. Some investors have a fixed number that they go by and are not willing to negotiate. Most investors agree that this number should be the amount of options the company will be granting when using the budget for the investment proceeds.
Therefore, when founders negotiate the valuation for an investment in their company, it is also important to understand the percentage of the post-closing unallocated ESOP reserve that the investors wish to have for the company – as this may cause a de-facto lower valuation (from a dilution perspective) than the founders originally intended.