ESOP's Fables: How to build a future-proof stock options framework

Let’s consider this hypothetical situation. 

You are an early-stage entrepreneur who just pieced together her founding team and are ready to roll. You offered generous ESOPs to get the best people and improve your chances of success.

Cut to six months later. You are in the market for a seed funding round. However, a few interested VC funds are miffed with the fact that you didn’t carve out an ESOP pool and your cap table has gone haywire.

Three years later, you get an acquisition offer. Half of your founding team has left, and some have even left the country. Now you are left scampering for signatures from people you can no longer trace.

This is a tiny set of problems that come with ESOP or Employee Stock Options Plan. Previously, the benefit was earmarked as an important component of compensation structures, exclusively for senior leadership or middle management who came with salary cuts. In the current scenario, they have assumed a significant role in attracting and retaining talent across all levels. For most startups, matching high market-matched salaries is difficult as they don’t have huge funds. But that doesn’t take away from the fact that they still need a talented team to scale. That’s where ESOPs play a pivotal role – they provide a partial right to ownership to employees.

 However, before we get into the details, getting jargon out of the way is essential. 

Let’s start with a small glossary of terms that may be helpful for founders:

• Grant: The first stage is referred to as a grant. The eligible employees are given share options on a particular date, which is known as the grant date.
• Vesting: The next stage is called vesting, which is about earning an asset over some time. The duration is known as the vesting period, which is the time between the grant date and the date on which the option holder can exercise their right. It is not only the duration – sometimes, vesting is also dependent on an employee’s performance, which is known as performance-based vesting. There’s also event-based vesting, which is likely to become a lot more common in the future. This is when an employee’s options vest based on the company’s KRA.
• Exercise: The last stage is called exercise. Once the vesting period is complete, the employee can exercise the option. The date when they decide to do that is known as the exercise date, post which the company allocates the shares to the employee, which adheres to the employee stock option scheme.
• Strike price: This price denotes how much an employee will pay to exercise a share of the company’s stock.

Balancing rewards and risks 

Now that we are familiar with the ESOP terminology, it’s important to dive deep into the right way of building an ESOPs strategy. Let’s start with hiring the right talent. 

There may be situations, where employees are ready to entirely forgo their salary because they want to bet on the company’s future and potential long-term wealth creation. In this case, it is better to infuse more friendliness into the options to account for the added risk. 

In a chat with Sanam Rawal, Business Head at MetaMorph (a strategic services unit incubated by Blume Ventures), Nishith Rastogi, Founder and CEO of Locus, a platform that optimises logistics operations for enterprises, let us in on his approach.

Take the example of someone whose current salary is INR 30 lakhs, and a startup offers them INR 60 lakhs of stocks.

“Let’s say someone’s house runs comfortably at 30 lakhs, you will make life-changing money for them…If you're expecting to grow 5X, INR 60 lakhs into five will become three crores at the end of four years when their vesting period ends,” he explained, adding that “when employees want to do something later, they are not thinking about their day-to-day money, and that’s what is the key.”

But can stocks be offered to anyone? They can be given to either part-time or a full-time employees since the law doesn’t differentiate between the two. However, an employee who is associated with the promoter group in any way, directly or indirectly, or has more than 10% of the equity of the company, cannot hold ESOPs. 

Moving on to an effective ESOP strategy, Rastogi advises that at an early stage, it changes between “zero to five, five to 20 and 20 to 50.” Someone joining when your company has less than five employees should get at least between 0.25-1%; if they are a leadership-level candidate, they should have a few integer percentage points. “…when people are joining you as a third, fourth team member, they're taking a big risk,” he shares, adding that they never hired anyone until they raised a seed round. 

Also, do not forget to create equity pools for everybody from the founder to the employees. This should be done right at the beginning; don’t shy away from having a larger pool if you like.

Best practices to follow while deciding your ESOPs framework

1. Don't get heady with emotions

While having a soft spot for your early employees and rewarding them for being with you from day one is a great idea, giving them ESOPs for the lowest possible price is a solely emotional decision and may not hold you in good stead in the long run. In case you allow an employee to hold the stock for an indefinite period, it can be an issue later if they are no longer in contact with you or have moved countries. That’s why go ahead and define a vesting period that does not exceed five years.

In most cases, 18 to 24 months is a good period for a company to raise another round. This proves beneficial for outgoing employees, who can then get enough time to decide on their ESOPs. When there is a new round, ESOP pool expansion is the biggest priority and generally happens in the presence of incoming investors.

2. Time is money

“The reward will be there, people will be able to enjoy value appreciation and bid well, but only for the time they are going to be a part of the organisation and from the time they join,” says Ashish Fafadia, partner at Blume Ventures. The challenge here is that the employee is being rewarded for the time they worked in the company, but not for the value that is created after they left.

Avoid double or triple acceleration, because it would allow certain ESOPs to reach a particular milestone or get an acquisition offer. This may lead to one employee being in a more favourable position than the other, which may create further conflict and sully the reputation of the company.

3. Communicate, communicate, communicate

While ESOPs work great as a means of wealth creation for employees, issues can crop up when there is a gap between what the company has promised them, and what they expected. That’s exactly why it is important to lay down a framework so that such hurdles do not come in the way of hiring the right talent.

The ESOP framework changes many times as company raises new funds and while it’s perfectly normal, remember not to take communication with your employees lightly. For any amendments in the ESOP strategy, inform your team so that they are not taken by surprise. By taking communication for granted, you run the risk of losing trust of your employees. Choose methodical documentation to convey any change, so that there’s no room for speculation. 

Generally, it is a good idea to have a session every quarter or twice annually for two reasons – one, because there’s a new set of employees. And two, new sets of questions generally come in by then. 

4. When in doubt, hire consultants

ESOP programs are technical and require a thorough understanding of tax, accounting, and legal aspects to come up with the right scheme for the company, employees, and investors. Bringing a consultant on board who has deep experience in creating ESOP programs prevents problems later.

While you may design the plan considering the startup will continue to operate you should also consider exit scenarios like merger and acquisition and IPO. We recommend that only experienced ESOP professionals should design a program that safeguards the interest of employees and the startup in different scenarios.

5. Block an ESOP pool on your cap table

A company needs to be clear about its cap table on a fully diluted basis. This move will help them consider all kinds of dilutions that are related to the future conversion of securities, including the ESOPs. This will also give an idea to the founders about how many employee options can be given, and the kind of dilution that will occur once the options are exercised in the long run.

Ashish Fafadia believes that it is important to have the ESOP pool in the range of 10-15%, which includes ESOP offered plus ESOP to be offered. For him, series A is the point, where the journey of monetisation and scaling begins.

Rastogi warns against carving out an ESOP pool under 10%. “We kept it at 10% and with every round because your pool dilutes, we also up the pool back close to 10%. This way your incoming investors will also dilute as you will have more ESOP pool expansion. A startup is not a zero-sum game. It is a value-creation game. So, nobody needs to lose for somebody to win,” he clarifies. 

Make sure you don’t ignore tax implications

Often, ESOP schemes push employees who are on their way out to exercise their vested options within 90 days of quitting, even in the absence of liquidity. If they don’t go ahead, their stock options expire. This is concerning because employees have to spend money out-of-pocket, which also leads to tax implications. Unfortunately, due to this glaring issue, a majority of such employees miss out on ESOP’s upside.

Moreover, it is equally important to educate your employees about the tax structure. ESOPs are taxed twice, unlike any other benefits provided by a company. Here, taxation occurs when employees receive stocks, and when they sell their securities.

If a startup has DPIIT registration, it helps employees in deferring taxation of ESOPs, as per the Finance Act 2020, In this case, the tax is to be paid at the end of five years from the end of the financial year, in which shares are allocated, or from the date of sale of such shares by the employee, and more.

To make things easier, walk employees through the best options for them, and find a way to provide liquidity so that they can fund the tax.  

ESOPS as a talent branding competitive advantage

Rastogi highlights that while ESOPs are often viewed as a retention strategy by most startups, Locus follows a different approach. For them, employee stock options serve as a reward mechanism. “Cash is cheaper than stocks because stocks have an opportunity cost. Most of the Blume portfolio companies, often when they raise on their own, are oversubscribed rounds,” he adds.

He recommends startups give employees stocks in two parts – one for building ownership to ensure cross-team collaboration, and the other to reward their performance. At Locus, they have a 10-year exercise period, but they will never force anyone to sell their stocks when they quit.

“One of the things we can’t check is commitment; that’s the mutual trust we are taking on. But after that, it’s a monthly pro rata. If somebody has worked for 21 months, they get stocks for 21 months; it’s not an annual thing,” he explained.

Generally, the strike price of options is their par value since it helps attract talent even if the company does not grow significantly. Locus has their exercise rate lower than the strike. He believes that since their exercise rate in the last round is lower than the strike, it may help to attract good talent.

But this might not always be a great idea, according to Srinivas Katta of the equity management platform RuleZero. For example, when it comes to senior employees, you’d want them to benefit only from the growth that happened after they joined the company as that’s where they played a meaningful role. So, in this case, you’d ideally grant higher options but at a higher strike price.

Here’s another thing to note: even if the employees are not with the company, this gets counted toward the total number of shareholders a company can have.

We will end with a few quick tips to keep in mind:

• Conventional distribution works when the same team is going to take the company from zero to IPO, ensuring a healthy balance between the availability of capital and talent simultaneously.
  
• One should classify every person's role in the organization, including the individuals at the founder's level. As you create a mega organization, each bucket should be reasonably compensated to make a significant impact on each bucket.
  
• The vesting period depends on the company's stage and its compensation plan. The lowest vesting period should be 4 years. Accelerated vesting could be used for best performers but should be based on target-based performance.
  
• It’s not possible to force an existing employee to sell their shares but if the employee has left, it is fair to coordinate and acquire a certain percentage of stock from that employee.
  
• Exercising options makes an employee a shareholder, so it's better to keep the conversion at a minimum. If the management converts this option, they should be allowed to hold it. In the case of other employees, it's advisable to settle it with the help of bonuses and liquidity.
  
• If an employee forfeits options, pay a bonus in place of ESOPs and the employee needs to pay tax at the highest slab.
  
• To replenish ESOP pools after each funding round, the company would need to reallocate shares to the pool, and readjust the capital structure if there is an excess allocation for angels or groups of angels.
  
• Very few choose monthly vesting; it’s generally quarterly. It’s not a size-of-the-company question – instead, it is an HR question. Ask yourself: do you want to set more employee-friendly or company-friendly options? Then reverse-engineer from there. 

“Whatever learnings and culture that have developed in the company; one needs to have a pulse and be able to change those on a time-to-time so that it reflects what the organisation needs. And whatever changes you make become applicable prospectively, where employees have joined from there on or grants that are made from there on,” concludes Fafadia.

ESOPs need a unique treatment within a startup's hiring strategy because your employees’ future gets tied to the company’s, and hence it is important to ensure they share the same vision. And a good ESOP framework ensures stock options respect the passion that talent brings to the startup.