Demystifying Term Sheets: Part 2 - Understanding ESOP

Demystifying Term Sheets: Part 2 - Understanding ESOP

Negotiating a term sheet can feel like walking a tightrope, a delicate balance between ambition and protection for both entrepreneurs and investors. Every line of a term sheet carries weight, telling a story about the future of a business. Drawing from years of experience in the VC play, we are pulling back the curtain to highlight what really matters in a term sheet, how both sides should approach it, and the lessons we have learned (sometimes the hard way) to avoid common pitfalls.

In the spirit of transparency, we are sharing a copy of our full term sheet template here.

This article is meant to serve as a guide to navigating term sheet negotiations, highlighting the most critical clauses, and sharing tips for both entrepreneurs and investors. Our term sheet reflects how we do things differently. When our founders Gonzalo Martínez de Azagra and Igor de la Sota set up the fund, they did not just replicate existing VC practices, they built something that truly represents Cardumen Capital’s values.

That said, this guide is not set in stone; it is a living document that evolves as the market changes. But before diving into the details, here is an important starting point: a term sheet is not a promise to invest, in other words, it is not a legally binding document. Even when signed, it is not a guarantee of funding. Instead, it should be seen more as an agreement to keep negotiations private and, in some cases, to pause the company from exploring other offers for a certain period of time.

Now, let us get down to business. While every term sheet is unique, just like every investment offer, there are certain key terms that almost always come up in negotiations. Keep reading to learn what these are and why they matter.

In Part 1 of our Demystifying Term Sheets series, we explored the foundation of term sheets, focusing on valuation and key financial terms. In this installment, we delve into Employee Stock Option Pools (ESOPs)—a critical component that impacts both founders and investors. Understanding ESOPs is essential for structuring equity effectively, attracting top talent, and managing dilution throughout funding rounds.

What is an Employee Stock Option Pool (ESOP)?

ESOP allows companies to grant stock options to employees, giving them the right to buy shares at a predetermined strike price in the future. This serves as both a financial benefit and an incentive, aligning employees' interests with the company's growth and success. The ESOP helps attract, motivate, and retain talent by offering a stake in the company's future value. Its size and structure can change over time, especially as the company raises funding or expands, ensuring it continues to support talent acquisition and long-term business goals.

A common rule for employee stock options is that they vest over time based on a set schedule, usually outlined in a shareholder agreement. Most companies use a four-year vesting period with a one-year cliff, meaning employees do not get any vested shares until they have been with the company for a full year. After that, shares start vesting gradually. This setup encourages employees to stick around and recognizes that their contributions become more valuable the longer they stay.

Impact on Dilution

During early funding rounds, ESOP dilution usually affects founders' shares. Existing shareholders, particularly investors, are often protected from this dilution through specific clauses in the term sheet. At Cardumen Capital, as early-stage investors, we follow this approach, ensuring that ESOP dilution at the time of investment comes primarily from the founders' equity.

As the company progresses through additional funding rounds, dilution from ESOP starts to impact all shareholders, including early investors. However, new investors are typically shielded from this dilution through standard term sheet agreements. Many investors hold pro-rata rights, allowing them to purchase additional shares in future rounds to maintain their ownership percentage. This helps offset dilution from ESOP expansions and new funding rounds.

Key Takeaways

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‍Cardumen Insight

‍We recommend always defining a clear percentage for the ESOP to avoid unchecked dilution, which tends to increase as a funding round progresses. At Cardumen, we consider a 10% available ESOP at the start of each round to be sufficient and practical. A key tip for entrepreneurs is to resist the temptation to allocate excessive shares or equity to employees and advisors early on. If you truly believe in your company’s future value, create an ESOP budget with clear ranges for different employee levels. Stick to these ranges to avoid regret later. There is no universal formula for determining the right ESOP size, but companies should consider their founders' equity, geographic factors, and hiring needs as a starting point.