Dilution Dilemma: How to Offer ESOPs Without Upsetting Investors

Understanding ESOPs without Dilution

Implementation of an Employee Stock Ownership Plan (ESOP) will have an impact on existing shareholders and result in reduced shareholdings. This decrease is due to employee business owners planning to create new shares to be distributed to employees, thus reducing the percentage of existing business owners.

To illustrate, consider a company's ownership as a pie, with the pie symbolizing the total value of the company. When new shares are generated for ESOP purposes, the size of the pie expands, which is beneficial. However, the additional slice is granted to employees, resulting in a smaller ownership proportion for each existing shareholder, despite the total value of their shares remaining unchanged.

Dilution is a significant concern for existing investors and promoters when a company allows new primary shares.

Let’s go through a few examples of dilution in startups which later resulted in them becoming one of the successful organizations in their respective fields.

Example of Dilution in Startups

Slack : In 2019, Slack chose to become a publicly traded company through a direct listing rather than a traditional IPO, enabling current shareholders to keep a greater percentage of ownership compared to an IPO. Nevertheless, some degree of dilution still occurred. In spite of this, Slack has experienced significant growth since its public listing and is still considered one of the most successful tech companies globally.

Airbnb : Airbnb received $112 million in funding from venture capital and angel investors in 2011, and in return received equity from the company. The change resulted in a reduction in available capital due to dilution. But this change helped Airbnb grow, become profitable, and become one of the most successful startups of all time.

Effect due to Share Dilution

• Several investors strongly object to any decrease in their ownership share, as this can lead to a reduction in their voting rights, making it harder for them to obtain a board seat and diminishing their influence on the company. To prevent the dilution of their shares, they prioritize maintaining their ownership stakes.


• For specific investors, maintaining a particular ownership percentage is crucial. Owning more than 25% grants them beneficial ownership while exceeding 50% gives them controlling interest. These shareholders often have a significant impact on the company's direction and are unwilling to risk diluting their ownership.

ESOP Allocation: With Dilution vs Without Dilution

However, companies can protect investors from dilution by carefully structuring ESOP plans. Here are some strategies to consider:

Steps to consider for mitigating ESOP dilution

1. Protection against Dilution in % Holding:

• Use of Phantom plan - Employees are given 'phantom shares' or units that mimic the value of the company's actual shares through a compensation plan known as a 'phantom plan.' These phantom shares do not represent actual ownership and are instead paid out in cash when they vest. This process does not result in the dilution of existing shareholders' ownership percentages. However, the company must allocate funds to cover these cash payments when the phantom shares vest.

• Buyback Shares - Buying stock in a public company using stock options is a simple process; the option has the right to buy the stock on the open market like any other investor. Private companies take a different approach. In this case, existing shareholders can sell some of their stock back to the company and engage in a joint buyback to cover the preferred work of the workers. This method allows the company to redistribute the ownership of the existing shareholders without the need for a new announcement, thus avoiding conflict. However, the company does require that it have enough cash to buy back the products from willing sellers.

2. Protection against Value Dilution

• Grant option at Fair Market Value - Issuing options at the current fair market value (FMV) of shares ensures that a company receives the same amount as if it were to issue shares to any investor, thereby preventing any decrease in value for existing shareholders. However, the challenge lies in accurately determining FMV, particularly for private companies. Granting options below FMV can result in shareholder value dilution.


• Performance-based Vesting Condition - It is possible to counteract dilution by tying option vesting to specific performance objectives such as revenue or profit growth milestones. When options only vest when the company achieves these targets, the increase in company value more than compensates for the dilution. Although dilution may occur, investors might be open to it if it substantially appreciates the company's value.

Wrapping up

To sum up, it's true that ESOPs generally result in dilution for current shareholders, but this dilution should not always be regarded as a purely negative outcome. The potential advantages of an ESOP, such as enhanced employee motivation and better alignment with company objectives, can overshadow the disadvantages. Moreover, companies can utilize different strategies to minimize dilution, thus preserving shareholder interests while cultivating a strong sense of ownership among employees. With careful planning and structuring of their ESOP plans, companies can create a situation that benefits both shareholders and employees.

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