To ESOP or Not to ESOP Myths, Fallacies, and Green Signals for Startups 0

Ankita-Singh-and-Yash-Vardhan-Singh

ESOPs can be an ideal business transition solution for many early stage startups, providing a way to preserve their legacy with employees and the community, get a fair price, retain a role in the company if they like, and get unmatched tax benefits in the process. Then why do startups tend to overlook their immense potential and what are some of the common myths around ESOPs that keep startups from taking the leap? Let’s find out.

The workforce is the metaphorical brick and mortar to any business and startups are no exception. If anything, there is an even more direct correlation between scaling and workforce quality in the startup ecosystem. For startups, the missing privilege is affordability. Enter the Silicon Valley-inspired textbook approach to compensation: The option!

The option is better known as the Employee Stock Options Program/ Plan (ESOP) or the Virtual Stock Option Program (VSOP). It is an option for employees to exchange parts of compensation for a stake in their employing organisation’s equity structure. An ESOP is essentially a long-term incentive granted to employees to buy or subscribe to the company’s shares at a predetermined price. This way, grantees are offered equity compensation instead of or in addition to their remuneration and in turn, become a part of the growth of the company and enjoy the sense of ownership thereby boosting the morale of the workforce. This ESOP/VSOP structure helps the organizations to negotiate salary structure with the employees and carefully strategize the manpower recruitment considering the cash strapped status.

What the ESOP/VSOP poetically is at its core is an option against mediocrity for a startup.

Indian startups were initially tempted by the commercial sense in ESOPs/VSOPs – save money while building quality products at scale. That vision is beginning to blur. Through ESOPs/VSOPs, scale is achieved on the back of undercompensated, over-performing employees in the present. Profitable startups then pay back such employees in the future. Everybody wins.

While that commercial principle underlying the instrument hasn’t changed, its testimonials in India’s new tech economy have shifted. India is now steadily seeing proof of it having actually worked. Be it the fortuitous case of Udaan, fortuitous because of the unique combination of facts in its favour that are not available to most of the startups, currently. India is envisioning ESOP-backed success, scaling and exit stories, or even enough exit or IPO stories in the startup ecosystem. In the meantime, the eroded confidence of employees in this option is beginning to pace up. The reason is straightforward. Foundationally, the three big hopes from an ESOP/ VSOP scheme for a start up are:

Founders need to understand ESOPs inside out and play their cards right as the dilution of founder equity is involved at every stage. Some wrong moves and the house of cards might crumble! Investors in order to avoid their dilution generally ask the founders to carve out an ESOP pool of 11%-12% pre-investment such that post investment the ESOP pool is left with 10% which is used to incentivize and retain the employees.

i) To attract a driven core team of management and initial employees who have their interests aligned with the interests of the startup because they have literal financial ownership in it, on a small, uncompetitive budget.

ii) Reduce employee churn through a limitation on when employees can sell their stake back to the company. Replace attrition with entrepreneurial behaviour and long-term thinking.

iii) Reward lasting impact (in a startup’s growth) with lasting impact (in the employee’s life) instead of one-time bonuses. A no-brainer.

Achieving these results will truly fulfill the work of the ESOPs to help start-ups shift from an imprudent “Cash is King” to a farsighted “Cash preserving” policy. Founders need to understand ESOPs inside out and play their cards right as the dilution of founder equity is involved at every stage. Some wrong moves and the house of cards might crumble! Investors in order to avoid their dilution generally ask the founders to carve out an ESOP pool of 11%-12% pre-investment such that post investment the ESOP pool is left with 10% which is used to incentivize and retain the employees.

We are now seeing the new trend of founders adopting the ESOP pool for themselves in order to increase their stake in the company and keep their skin in the game as their equity percentage is crucial for future fundraising. This new trend has emerged since DPIIT vide its notification dated 19th February 2019 has allowed promoters of DPIIT recognized startups to participate in the ESOP scheme.

However, it is still an option which many start-ups are not keen to consider, either due to the fact that they don’t know what an ESOP is or have been misled about how these work. ESOPs can be an ideal business transition solution for many early stage start-ups, providing a way to preserve their legacy with employees and the community, get a fair price, retain a role in the company if they like, and get unmatched tax benefits in the process. But startups tend to overlook its immense potential through unadvised ESOP/VSOP life cycle management practices.

Life cycle management would include the step by step progression that takes startups from assessing whether an ESOP fits into their company culture and stage of growth, setting up ESOP structures, to deciding the pool size, the vesting period, and, where applicable, the cliff period, the contingencies that support company culture – such as a good leaver/bad leaver policy, to compliance with company and tax laws, tax calculations, documentation to keep employees informed on ESOP management and making sure everyone fully comprehends benefits and pitfalls, comparing the change of ownership alternatives, feasibility study and administering ESOPs.

Any of this done or skipped in a hurry causes experiences that trigger some bad beliefs about ESOPs. We’ve identified six such misconceptions.

Cost And Complexity of Set-Up

Startup owners may frown upon the perceived advisory costs of setting up and managing the ESOP. Associated advisory services fees may appear to intimidate them. And the cost of dilution without comprehending the direction the ESOP scheme is taking may intimidate founders even more. We believe that along with the cost we must also ensure that the advisor working with the company that is setting up the ESOP scheme should be well versed with the concept of ESOP. We have dealt with many companies who have got their ESOP implemented from some consultants who are not well versed with the concept of ESOP and have missed on key aspects such as what will happen to the options granted to the employees which are vested and the employee has resigned from the company without cause. We deal with such kinds of situations by incorporating a clause that if the employee resigns, he/she needs to exercise the vested options within a predetermined time of resignation, if the employee does not exercise their vested options within such time, the vested options shall lapse. When we draft an ESOP scheme for the company we take a holistic view that the ESOP scheme is a win-win document for both the company and the employee and the employees specifically should not be left behind with crumbs.

Cost of Repurchase / Liquidity

Ankita Singh & Yash Vardhan Singh 2

 

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Founders worry about opening yet another cycle of constant repurchase obligations by opening the door on an ESOP scheme. But that is just what it is. “Another” repurchase obligation. Repurchase obligations are tied up into the definition of companies. Renowned pitch-deck coach Alexander Jarvis jokes: “Dilution happens like shit happens.”

What he means is that going into business with a multiple stakeholder entity is by definition a cycle of dilution and repurchase. If you raise money, hire staff, engage in M&A, give shares to lawyers when you are broke, you are going to get diluted. Similarly, any closely held company has a 100% repurchase obligation all the time; ESOPs are no different. If employees buy shares directly, such as in a management buyout, they too will want liquidity for their shares at some point, however, the company should be able to structure it well in no uncertain manner.

At some point, the employee would be keen to liquidate their shares which can either be achieved through repurchase, either by the company or in any other liquidation event which should be a win-win for all. To get to the winning strike, the startups generally connect exercise of ESOPs with liquidity event which can be defined as an event wherein the company has an offer for merger/acquisition, company going for an IPO, or an event by which the majority of the assets or voting power has been sold to any other entity. The rationale behind the connecting exercise of ESOPs with liquidity events is that just after exercising, employees get an option to sell their shares. Paytm has followed the same structure. It has given out the largest ESOPs as a startup in the company amounting to INR 6.1 crore shares just before its $2.2 billion IPO.

Business Transition Cost

Founders may also be sceptical about the opportunity costs associated with opting into the ESOP. “Can’t I get more out of a synergistic buyer than an ESOP investor/employee?” they may ask. The first principle to consider is, is the company in the stage of benefiting from a part-cash, part earn out consideration? Because that is what competitors pay. ESOPs, in contrast, pay whole cash. Also, in the case of a sale, there may also be financing or personal contingencies, such as earnouts or requiring the seller to stay or leave.

Also, forget about the deferred capital gains tax on the sale, as compared to having that benefit in the case of ESOP. Pragmatism says that ESOP as an ownership transition strategy is the way to go for a majority of startups and only an exceptional minority can get a meaningfully higher price from their company’s acquisition.

Cost of Transparency

Startups work in the private investment ecosystem because they are wary of disclosing too much competitive information. By extension, they are also wary of disclosing too much financial information and governance to the employees.

However, ESOP schemes have no such mandatory sharing requirements. Companies need only provide annual account statements indicating the total value of the account, vesting status, and share value. The ESOP is governed by a trustee appointed by the Board of the company or the Board itself.

That said, choosing to be transparent works in favour of companies with ESOP schemes.

India’s tech ecosystem is fast evolving into a space where everyone wants ESOPs but as a cherry on the cake and not as a trade-off of the actual compensation. To the extent that start-ups now not providing ESOPs over and above salaries are acquiring the flawed brand perception of bad employers.

 

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However, how many employees have been able to effectively cash out ESOPs, in a way that makes for great testimonials for the company? There aren’t many such stories because employees do not really comprehend the full scope of ESOP and the strategy for their ESOP looks to be a long road ahead but not unachievable.

Another scepticism on the part of under-compensated employees could be that ESOPs are one-sided (in favour of the company) because they are not diversified. So it would help to have documentation to explain how employees’ sensitivities are kept in mind while carving out the scheme including the tax deferment on the exercise of options.

Research in the US indicates that companies that combine ESOPs with what we call an “ownership culture” (they share financial information and get people involved in work-level decisions) grow 6% to 11% per year faster than would have been expected; companies with top-down cultures grow more slowly post-ESOP than would have been expected. In other words, an ESOP works if part of an overall culture, not all by itself. Just having the culture without the ownership, by the way, doesn’t work very well either.

Considering the employee is required to bear the tax as a perquisite paid by the employer to the employee under Section 17 of the Income Tax Act, 1961, the moment the options are exercised, we advise the ESOP schemes to connect the exercise with the liquidity event (as also discussed above). This practice allows the employee to exercise the options only prior to the liquidation of those shares and the employee will be more than happy to bear the burden of tax at that moment when there is sure shot cash coming to such employee. With no connection to the liquidity event, the employee could have been burdened with tax implications without being surety to the liquidity event happening in the near future or even at all. This inculcates greater confidence in the employees and they will be keen to consider the ESOP being part of their compensation structure. 

India’s tech ecosystem is fast evolving into a space where everyone wants ESOPs but as a cherry on the cake and not as a trade-off of the actual compensation. To the extent that start-ups now not providing ESOPs over and above salaries are acquiring the flawed brand perception of bad employers.

Cost of IncompatibilityAnkita Singh & Yash Vardhan Singh 3

 

Startups question if their niche is even in an ESOP-friendly industry, to begin with. But our experience suggests that ESOPs are industry-agnostic, in terms of their effectiveness. 

Cost of Esop Loans

ESOP loans have a very low default rate, so banks that have some experience in this area typically will view them more favorably than other highly leveraged transactions. If bank credit is not available, however, sellers can finance the sale directly by taking a note, with the ESOP paying an equivalent arms-length interest rate. However, the ESOP loans are still to see the day of light in the Indian start-up ecosystem.

Good Reasons Not to Do an ESOP 

COST OF OWNERSHIP CULTURE

Some company managements are culturally just not comfortable with the idea of giving more information about, and more say in, the affairs of the company to the employees. In such cases, to literally give out ownership, without culturally creating “ownership” may demotivate employees and backfire.

DOUBLE TAXATION ON EMPLOYEES

Another very important reason why the ESOP fails to attract employees is the double whammy of taxation which employees are subject to under the Indian tax regime. The employees have to pay tax initially at the time of exercise and also in the form of capital gains at the time of sale.

DOWN ROUND IN THE COMPANY

Whenever the start-ups raise an investment which is a down round, i.e. the valuation of the company falls from what was there in the previous round, the employees lose confidence in the company because the value of options granted to employees under the ESOP scheme also goes down thereby demotivating the employees.

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Ankita Singh is the founder of Sarvaank Associates. The former head of transactions at the Indian Angel Network, Ankita specialises in investment/restructuring transactions, mergers and acquisitions, joint ventures, exit transactions, company formation, debt transactions and company law matters. Yash Vardhan Singh is a senior associate at Sarvaank Associates. A corporate, commercial lawyer with core practice in Start-up Advisory, Private Equity and General Corporate & Commercial Transactions, Yash works with start-ups. 

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