Dilution Dilemma: How to Offer ESOPs Without Upsetting Investors

Editor's Note:-This article takes an in-depth look at dilution issues in employee ownership strategies and suggests strategies to reduce their impact. It examines alternative models and valuation methods for balancing shareholder interests with employee incentives.

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.

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.

• 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.

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

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.