For many years, an employee stock ownership plan (ESOP) has been the ace up the sleeves of human resource (HR) managers for hiring and more so for retaining employees critical for the success of an organization.
Over the years many companies have tweaked the basic model and developed various iterations with versions like restricted stock units and phantom shares. But there are some differences in how they can be exercised and how they are taxed.
ESOPs can be used by both a mature company or a growth-stage company trying to retain their key employees. Most startups these days also ESOPs to compensate certain critical hires and make up for at par or even lower cash components in their remuneration package than what they may be already earning in an established organization.
Also read: To ESOP or Not to ESOP Myths, Fallacies, and Green Signals for Startups
As the organization grows and attracts a higher valuation either on the stock market or from other private investors in the case of startups, the employees gain from the growth of the company. Of course, they have to stick to the company and meet the KRAs rather than freeloading on the organization’s success.
The KPMG ESOP Survey Report 2021 provides a fair bit of insight into the ESOP landscape in the country. According to the report, as many as 68% of the companies they spoke to either had a running ESOP program or were planning to implement one. While there are many options like warrants, debentures or even cash for what can be offered as ESOP payouts, the KPMG report points out that equity is the overwhelming favourite.
The dilemma
What happens if the value of the company skids for some reason?
That’s the dilemma facing many small and large companies currently, not to forget startups. The sharp correction in the stock market and poor performance of some companies after their listing have changed the complexion of the ESOPs from boon to bane.
Take Ujjivan Small Finance Bank, for instance. The small finance bank went public two and a half years ago with much fanfare. Changing itself from a microfinance company to a small finance bank and roping in a high-profile CEO from HDFC Bank was the relatively easy part.
What followed thereafter with the fight between the old guard and new management resulting in a large-scale top management exit is just one part of the story. On the flip side, the crash in the value of the company after listing has pushed its ESOPs underwater and made these redundant.
As per the company’s IPO prospectus, it granted 37 million options to employees at an exercise price of Rs 35 each. The company’s share price is currently at just half that level!
To be sure, there are workarounds. One can reprice the exercise price, for instance. But that needs a buy-in from existing shareholders, which is not guaranteed.
The small finance bank is not an exception. The current state of stock markets has turned a lot of options granted to employees underwater. This means, that the ESOPs are unlikely to be exercised and, therefore, are redundant.
Take Ujjivan Small Finance Bank, for instance. The small finance bank went public two and a half years ago with much fanfare. Changing itself from a microfinance company to a small finance bank and roping in a high-profile CEO from HDFC Bank was the relatively easy part. What followed thereafter with the fight between the old guard and new management resulting in a large-scale top management exit is just one part of the story. On the flip side, the crash in the value of the company after listing has pushed its ESOPs underwater and made these redundant.
Startup: La casa de Papel
If we look at the world of startups where ESOPs have created a mountain of wealth, things are a bit different. The exercise price for the options for most startups, including the more mature ones that have gone public in the recent past, has been very generous. This ensures the employee holding the option will gain from the company over time and could potentially turn into a millionaire.
In the past, the only way out for an employee to gain from the ESOPs was for the company to get acquired, which was a rare event. But over the last four-five years, several other modes of liquidity have cropped up. These include company buybacks, which is bankrolled by a fresh cash infusion from new investors at a higher valuation; direct purchase from new investors, who tend to create liquidity for the employees; and a public listing, which opens a whole new world to convert the options into shares and sell them at will.
As a result of increased competition for good resources, some companies went one step further and have been offering ESOP buybacks at regular intervals.
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However, the impending slowdown in venture capital funding for startups is likely to create a liquidity problem. In simple terms, many startups may end up allocating shares, but will not be financially sound enough or will be able to get additional funding to buy them back, ever. So, an employee can only bask in the glory of paper wealth based on the last funding round of the company.
Unfortunately, this issue rarely gets talked about. But recently, taking to Twitter, Zerodha co-founder Nitin Kamath said that the ESOPs issued by many startups in the last three years could be out of money.
The sharp fall in the stock prices of high growth tech companies across the globe is getting crazy, feels like the dot-com boom.
India has weathered the storm mostly because not many such companies are listed & many private ones raised a lot of money last year. 1/7
— Nithin Kamath (@Nithin0dha) May 10, 2022
This may work for a while, but eventually, employees figure out that those ESOPs are worth much less than what they appear to be.
Allotment and vesting
The second challenge with ESOPs in the Indian context is of allotment and vesting. Mostly, ESOPs used to be a one-time affair, allotted upon joining. Facing market pressures, more and more companies are now moving to annual or even monthly allotments.
The KPMG report cited earlier states that as many as 47% of their respondents now do annual allotment. But allotment alone is not enough for ESOPs. They need to vest and there is normally a vesting period. The share becomes the employee’s-only after the vesting period. Initially, the vesting periods were long, usually three or five years. Now, consider the IT industry, with an annual employee attrition rate of 30%-plus. Obviously, such long vesting periods do not work and employees tend to ignore the impact of ESOPs in their salary negotiations.
There has been a move towards shorter vesting periods. As a make-good during the pandemic, some companies allowed early vesting of ESOPs, including for employees who were made redundant or otherwise terminated during the period.
This year, partly to offset pandemic-induced salary cuts and partly due to other reasons like increased demand for skilled employees, we have seen an acceleration in the buyback process. This worked till now as the flush of liquidity boosting the availability of VC money in startups allowed firms to provide some cash to the workforce. But there is a big question mark on how long can the tech startups hope to continue attracting tech talent from large IT companies as the VC party comes to an end.
There has also been heartburn with ESOPs on two counts. What’s promised and what’s eventually offered with some employees quitting over disagreements. For instance, former Paytm Money chief Pravin Jadhav had reportedly quit the firm over various disagreements including ESOPs.
At the same time, barring a few exceptions, ESOPs remain a preserve of the top management. While this works as an aspirational tool for junior and mid-level executives to strive for, to make it a more inclusive tool for employee ownership and incentivizing them to work for the growth of the company it needs to become more broad-based for the organization as a whole. Till that happens, to take care of the new realities of the job market, the lure and effectiveness of ESOPs for the company will get diluted.
So, what is the verdict on ESOPs? Are they going away? Quite to the contrary. ESOPS are here to stay, but do not expect them to be the one-stop answer to all hiring and attrition problems.
