This article is relevant to startup founders, private limited companies, investors, venture capital funds, angel investors, and legal or corporate advisors operating in Malaysia. It provides an overview of the Employee Share Option Plan (“ESOP”) and key legal, commercial, and investment considerations commonly arising during fundraising exercises involving private companies.
What is ESOP?
An ESOP is an employee incentive scheme which grants eligible employees or key personnel the right (but not the obligation) to subscribe for shares in a company at a predetermined price, subject to vesting conditions and other terms. ESOPs are commonly used to attract and retain talent, reduce immediate cash compensation burden and create a sense of ownership among key team members. For private limited companies in Malaysia, ESOP implementation must also comply with:
- the Companies Act 2016;
- the Constitution of the company;
- shareholders agreement;
- ESOP By-Laws or scheme document;
- applicable corporate approvals; and
- tax considerations.
Key Commercial and Legal Considerations of ESOP in Fundraising
1. ESOP Pool Size: One of the most heavily negotiated points during fundraising is the size of the ESOP pool. Typically, companies establish an ESOP pool ranging between 5% to 20% of the enlarged share capital. However, the size of the ESOP pool directly impacts founder dilution, investor dilution, and post-investment ownership percentages. Accordingly, the ESOP pool should be carefully considered before the fundraising is completed.
From a founder’s perspective, the company should also assess whether the ESOP pool is sufficiently sized to accommodate future recruitment and retention needs. An undersized ESOP pool may require expansion in future financing rounds, which could:
- create additional dilution; and
- trigger renegotiations among shareholders and investors.
As such, founders should prepare a realistic hiring roadmap and talent strategy before negotiating ESOP size with investors.
2. Pre-Money vs Post-Money ESOP: A critical issue in fundraising negotiations is whether the ESOP pool is calculated on a (a) pre-money basis; or (b) post-money basis. The distinction significantly affects the dilution borne by founders and other existing shareholders.
(a) Pre-Money ESOP: Under a pre-money structure, the ESOP pool is created before the investor subscribes for shares. As a result, the dilution is primarily borne by the founders and existing shareholders; and the incoming investor’s percentage shareholding is protected from dilution arising from the ESOP pool. Incoming investors generally prefer this structure because the ESOP pool has already been factored into the valuation and cap table before their investment is made.
(b) Post-Money ESOP: Under a post-money structure, the ESOP pool is created after the investor’s shares are issued. This results in dilution being shared between founders and incoming investors. Founders generally prefer this structure as it reduces the extent of founder dilution.
Small differences in calculation methodology can significantly affect founder ownership after multiple fundraising rounds.
3. Fully Diluted Capitalisation Table (“Cap Table”): The capitalization table is one of the most important documents in fundraising exercise. A properly maintained cap table should reflect ESOP allocations and reserved pools. Investors will typically review the percentage of the ESOP pool already granted, remaining unallocated pool, vesting schedules, exercise price mechanics; and dilution impact on future fundraising rounds. Errors or inconsistencies in the cap table may create unexpected dilution, disputes among shareholders or delays during legal due diligence.
Accordingly, founders should ensure that the cap table is regularly updated and accurately reflects all outstanding equity interests and convertible rights. Parties should clearly define:
- whether the ESOP is included in the valuation;
- whether unvested or unallocated options are counted as fully diluted shares; and
- the methodology used in the cap table calculations.
4. Legal Due Diligence: During fundraising exercises, investors will typically conduct legal due diligence on the company’s ESOP structure and documentation. Accordingly, companies implementing ESOPs should maintain proper and well-documented records, including: ESOP scheme documents and by-laws; board and shareholders’ resolutions; cap tables; register of options; option grant documentation. Common issues identified during LDD include:
- undocumented grants;
- absence of shareholder approvals;
- inconsistencies in the cap table; and
- options granted beyond the approved ESOP pool.
Such issues may delay completion, require rectification exercises or impact negotiations.
Conclusion
An ESOP is no longer merely an employee benefit mechanism. In modern fundraising transactions, it is a key commercial and strategic component that directly impacts:
- dilution;
- investor protection;
- employee retention;
- company valuation; and
- long-term scalability of the business.
A properly structured ESOP can enhance the attractiveness of a company to investors while simultaneously helping founders build and retain a high-performing team. Conversely, poorly documented or improperly managed ESOP arrangements may create significant legal, commercial, and fundraising complications, particularly during legal due diligence and future investment rounds.
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This article was written by Low Rui Thong (Associate) from Donovan & Ho’s corporate practice.
Our corporate practice group advises on corporate acquisitions, restructuring exercises, joint venture arrangements, shareholder agreements, employee share options and franchise businesses, Malaysia start-up founders and can assist with venture capital funds in Seed, Series A & B funding rounds. Feel free to contact us if you have any queries.
