An Employee Stock/Share Option Plan (ESOP) can provide technopreneurs with an important tool for attracting and retaining key talent to help build and scale their early stage startup. But how are these share options managed within the context of a capital raise?

As a technopreneur you will be familiar with the challenge of attracting and retaining good quality people, competing with established businesses such as large financial institutions that pay much bigger salaries. You should absolutely use share options, as it not only attracts people with the right skills that you require, but also attracts the right kind of people for your startup.

People who are not only prepared to take some risk on their compensation upside  ( as opposed to the usual “pay check junkie”), but also believe in the business and its prospects. Share Options also help to motivate employees on an ongoing basis where they will feel like owners or partners in the business.

A share option is a contract that gives an employee the right to purchase shares in the company at a specified price (also known as the strike price) by a specific date. The employee is under no obligation to ‘exercise’ any or all of their options. Often an employee’s options will ‘vest’ over time, meaning that not all options will be exercisable immediately but become so over a fixed period of time.

If an employee leaves the company or is fired, they typically have a fixed period (usually 90 days) to exercise their unexercised options that have vested or they implicitly forfeit them. Employees will typically forfeit any unvested options. Share options also usually vest in a liquidity event, such as the company being acquired or IPO’ed.

Startups establish ESOPs as part of an overall employee compensation plan, and will typically issue 10-15% of its total share capital to the option pool at around the Seed or Series A stages.

So how do you manage an ESOP in a capital raise?

The size and structure can be decided unilaterally by the technopreneur and presented to investors as a fait accomplice , but in reality is often discussed with prospective investors during a capital raise. There are two ways of dealing with the ESOP, depending on whether it is allocated before or after the investment.

The investor-friendly approach, which is also called a ‘pre-money pool,’ gives the investors a greater share of the company. In this approach, employee share options are allocated first, and then the investor is allocated their shares. As a result, the investor share allocation dilutes the share option pool, and therefore the VC ends up with a greater percentage of the company.

The technopreneur-friendly approach, also known as a ‘post- money pool,’ is the opposite way of issuing shares to investors and ultimately gives them a smaller share of the company. The investor is allotted shares first, and the option pool is created subsequently. The effect of this is that the investor’s shares are diluted by the new pool and they end up with a smaller percentage of the company.

The option pool will be included in the cap table’s fully diluted ownership, but will not have the right to exit proceeds before the options are in the hands of an option holder with the right to exercise. So until the company starts granting options, all capital proceeds will be shared between the technopreneur and their investors.

Warrants are similar to options, however they are not issued through the company’s ESOP abut should also be shown in the cap table. Nevertheless, the board and shareholders still has to approve warrant allotments.  The value of warrants for their holder is the difference between the strike price, which is typically set at fair market value on the day of issuance, and the fair market value of the company’s share price on the day of exercising.

Stock options can and should be used to attract and retain talent. This article provides guidance to technopreneurs on how to discuss these with investors within a capital raising process.