As valuations continue to rise, early stage VCs are getting more “creative” with their deal structuring. In particular, I’ve seen a rise in requests for ESOP shares to be allocated to lead investors for their “value added services.”
It’s common to give ESOP to advisors for their value add, so why not investors?
Misalignment
A lead investor is usually aligned with their co-investors to negotiate with founders for a pre-money valuation at a level they deem fair. But when a lead investor asks for ESOP shares in addition to what they purchase, they are setting a higher PPS for others joining their round, without actually having to pay it themselves.
To illustrate: Let’s say a company has a pre-money valuation of $8 million, and is raising $2 million. The lead investor puts in $800,000 for 8 percent of the post-money equity, but also includes a provision that they will receive 2 percent in ESOP. This means the effective price per share the lead VC pays is 20 percent cheaper than that of his co-investors.
Side Effects
Putting aside the moral and trust issues that arise when you give a lower PPS to some investors in your round over others, there are other negative side effects to be considered.
Like every other term you give in on in the early stages, this may set a precedent for downstream investors. In the same way that giving aggressive liquidation preferences and pro-rata rights to your early stage investors may hurt you down the line as these begin to stack up, giving ESOP to your lead investors for their “value add” can become a pain as you try to manage these expectations in downstream rounds.
ESOP is for attracting and retaining a good team.
Within the round itself, if you still need more investors to get to closing, providing ESOP to the lead investor will make it more difficult to do so. This isn’t a problem if you are targeting investors who don’t pay attention to these details. But others who also consider themselves a “value add” (hint: this includes most professional VCs/angels) will likely ask for their own sweeteners to make up for the discrepancy.
What To Do?
If you can’t get the deal done without providing ESOP to your lead investor and you really want/need this investor to join, at least try to minimize the impact and maximize the benefit.
First, make them really “lead” the round by investing a majority of it. The effects of giving ESOP to lead investors become more pronounced when the VC is contributing less in the round. By investing a high percentage of the total round, this lowers the impact the ESOP has on their effective price per share, and makes it easier for you as a founder to close what remains of your round with passive investors.
Second, to maximize the benefit of this ESOP, ask the investor to lay out more concretely what you’ll be getting for it, and make sure the shares vest over time. Be sure the level of support you’ll be receiving is at least comparable to what you can obtain from third-party advisors and service providers, and use the service agreement to hold the investor accountable over time.
Value Add?
As a founder who has been struggling to find the right lead investor, when the perfect one comes along singing songs of how much they’ll help you, giving them a little extra for their “value add” seems worthwhile.
But remember, ESOP is for attracting and retaining a good team, aligning them with your company so you can succeed. Your investors have enough motivation to help your company, and if they can’t justify their ESOP request in concrete terms and don’t care about minimizing its negative impact on the company, perhaps they aren’t so “value add” after all.