In many cases, an investor makes it a condition of their investment that an employee participation plan, also known as ESOP or option pool, be established or an existing plan is expanded. Founders generally agree. After all, attracting and retaining talented and well-motivated staff is essential, and offering to participate in a (favorable) participation plan can help. But what kind of plan should it be? And at whose expense/dilution does this come?

First, there are different forms of employee participation plans, including option plans, Stock Appreciation Rights (SARs), and employee shares. It must be said that it largely depends on your jurisdiction as to what kind of plan suits you best. The rights and obligations of the participants (vesting, good/bad leaver, etc.) are more or less equal in each form and fairly standard.

Then – who ‘pays’ for it? Is it “in the pre-money”, on “fully diluted basis”, or “in the post-money”? Will it be at the expense of all shareholders, including new investors, or will it only dilute existing shareholders? It frequently happens that the term sheet is unclear about this, which can lead to difficult discussions.

What is reasonable? If an option pool is set up to attract new employees, one might say that it makes sense to dilute the interest of all shareholders – including the investor – as a result. After all, all parties benefit if new employees can be presented with an attractive arrangement.

On the other hand, the thinking of investors is understandable: they base their valuation on a minimum stake they want to keep after this investment round, including the option pool. If the option pool is used to fulfill earlier commitments to existing employees, then it does not make much sense for investors to ‘contribute’ to this. Ultimately, it is a point of negotiation involving the effective pre-money valuation that the investor and founder are willing to accept. That is fine, as long as it is clear what the arrangements are, so that you, as a startup founder, can make an accurate comparison between the various term sheets on the table.

As Palo Alto-based business attorney Troy Foster (partner Perkins Coie) states in our Startup Funding Book:
“I think the right way to think about the situation is that the investment is premised upon the company having everything that it needs to be able to function in the ecosystem, including hiring employees, retaining consultants and providing proper incentives for those folks to perform. Having a share reserve for equity grants and an up-to-date plan just makes sense in that context.”

Read more insights in Startup Funding book, the book about investor readiness, fundraising and deal terms that I wrote together with venture capital lawyer Sjoerd Mol to help founders to nail their fundraising process. Order it via bol.com, Amazon or your local bookstore.