The Importance of ESOPs in Early-Stage Ventures

Through a series of blogs, the PwC Venture & Growth team are conducting research and providing insights into Term Sheets. This iteration of the series focuses on ESOPs and the importance of ESOPs for early-stage, venture-backed businesses.

According to Beauhurst data, there are currently 12.5k active, seed-stage businesses operating in the UK. This makes up 24% of active firms. Seed-stage businesses are at the earliest stage of their development. These companies are usually made up of a small team and have a low valuation. Funding for these businesses normally comes from grants or business angels.

What is an ESOP?

An ESOP (Employee Share Option Pool) is a form of a stock ownership plan that provides employees with stock options in the company they work for. By making stock options part of an employee’s remuneration, businesses can incentivise employees to help optimise the growth of the business. It also assists early-stage firms in attracting and retaining top talent, as well as achieving growth objectives, even in their illiquid states.

What were the findings of the PwC analysis?

PwC found that in the majority of venture term sheets (63.8%), an option pool was created, meaning that the creation of option pools is market standard. 61.9% of ESOPs were created in the post-money. For UK seed stage companies, the average valuation increases by 15.7% from pre- to post-money. When created in post-money, the existing and new shareholders both will see their shares diluted. For pre-money, this is only the case for existing shareholders.

Finally, the creation of option pools was 20% less common in 2022 compared with the previous year. It was suggested that this was due to tougher conditions for growth businesses, meaning investors must be more selective with capital allocation. Total equity investment for UK firms fell by 7.56% between 2021 and 2022 according to Beauhurst data.