Venture Capital Funding Startup Guide
What is Employee Stock Option Plan, ESOP, fully diluted shares?
employee stock option plan, esop, valuation, fully-diluted shares, outstanding shares
What is Employee Stock Option Plan (ESOP)?
In a typical venture capital investment, the investor and the company will agree to the creation of an option pool before the investor invests in the company. The option pool is also sometimes called an option plan, Employee Stock Option Plan, or ESOP - usually defined as the "Plan" in a venture capital term sheet. What ESOP means is that the company will set aside a certain number of shares in the company to be issued to employees at a future date.
What does fully-diluted means?
Fully-diluted means all outstanding shares plus shares issuable under warrants and options (whether actually issued or not). It is the maximum number of shares in the company in the event that all options and warrants are exercised.
For example, there are 5 million outstanding shares in a company, held by its founders and certain venture capital investors. 1 million shares are set aside for an option pool. Then, there are 6 million fully-diluted shares in the company. This is calculated on a fully-diluted basis.
Fully-diluted and purchase price per share
When calculating the purchase price per share in a company, the number of shares set aside for the option has to be taken into account.
For example, Company A has a pre-money valuation of 6 million dollars. There are 5 million outstanding shares held by its founders. In a Series A funding, the founders and the venture capital investor agree to set aside 1 million shares for an option pool. Then each share in the company is 6 million dollars divided by 6 million fully-diluted shares, i.e., 1 dollar per share.
The number of shares set aside for the option pool is taken into account, even though the shares are not yet issued.
Size matters
Therefore, a large option pool will drag down the purchase price. A common mistake entrepreneurs make is that they don't know the importance of negotiating for a reasonably-sized option pool.
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