This article is repurposed from conversation of Ashish Fafadia with Blume’s portfolio companies.
ESOPs, a largely equitable tool of wealth creation, is also often misunderstood or used sub-optimally. The conflicts start when there is a disconnect between what the company promised and what the employee expected. Not paying attention to ESOPs at the very beginning can end up with small hiccups snowballing into disgruntled factions of employees capable of inordinately delaying deal closures. With a little bit of nuance, this can be a great tool to sweeten the deal for critical hires.
When giving out equity to reward essential employees, there are usually two approaches adopted by founders – philosophical and logical. But it isn’t as straightforward as picking one out of the two to build your ESOPs framework. During the earliest part of the company’s journey, you would have little choice but to follow your gut and take a philosophical stand. In this case, you would want to help each member of the early team. Or you may take a decision that we want to be brutally objective and offer stocks very selectively. There is no right or wrong so far as the founders stick to their philosophy consistently. These decisions have a fair bit of emotion involved, and it is natural to want to compensate the dozen odd employees who moved mountains for an uncertain future.
The logical approach would be to ascertain the opportunity loss suffered by the incoming employees and make an offer that is directly aimed at compensating the employee with the opportunity loss and should the company achieve success, it results in meaningful compensation as well as wealth creation for the employees.
The debates start becoming more complex once you cross or start reaching US$ 200 Mn in valuation. The ESOP pool is now much bigger, and there are more people vying for a share because there is more trust and confidence in this form of currency. This is when logic starts to take precedence over philosophy. In this case, you need to make sure the employee joining you is compensated fairly for taking the risk. For example, if a person joining your company had a 40% pay cut, you must ensure you give enough ESOPs that compensate for it in the next three years. In fact, the employee shouldn’t feel it’s a paycut, but should be looking at your offer as an investment. Savvy finance leaders get this right but the issue still is subject to a prolonged negotiation or still worse heartburn due to the way some of the terms / clauses are drafted. Again here, the founders and investors need to make a fundamental decision on how they are going to handle the contentious issues and be transparent about these matters.
Keeping your options open
A benevolent founder would say that an employee should be awarded ESOPs at the lowest possible strike price, and should have the choice of holding them for a long time. This founder’s heart may be in the right place, but executing such an approach on the ground is tricky. Let’s consider that the employees can hold their stock indefinitely. What happens if you lose touch with the employee after a few years? What if she moves abroad and you have no way to contact? You would end up holding up key transactions if such a situation comes up.
An ideal tenure for vesting is three to four years, but even five works well. In most cases, 18 to 24 months is enough time for the company to raise another round. This also allows for enough time for the outgoing employees to make a decision on their ESOPs (as in whether they wish to exercise their options and convert to stocks or hold or forego), instead of making stress calls and losing the fruits of their contributions. Why is the new round significant? This is when the company would need to make calls regarding its ESOP pool. There would be decisions regarding pool expansion and a policy framework, and it’s ideal to do so in the presence of incoming investors. In this way, the company is able to free up the pool when there is a churn while keeping the employees happy with options for liquidity.
Secondly, keeping a low strike price is generous, but an employee’s reward should be commensurate with time spent in the company. Allocation is usually a function of seniority level, delivery milestones, as well as the opportunity cost of the employee. But would it be fair for an employee who comes in after five years to be awarded stocks at the same price that someone who has been around since the company was just a proof of concept?
Moreover, while acceleration is a great tool, double or triple trigger acceleration can do more harm than good. In this case, you would allow ESOPs before time in special cases such as reaching a particular milestone or getting an acquisition offer. However, the cap table is finite, and a double or triple trigger would end up benefiting one person at the cost of another, leading to feelings of dejection and bad faith. Hence, this option should be used sparingly or when the choices are limited.
The importance of straight talk
There is no one standard template that serves every company. For an effective ESOP policy framework, a company will have to relook its structure at every stage and make necessary tweaks. In this case, documentation is the glue that holds the framework together. For example, if one starts making retrospective amendments to its ESOP program at every stage, the company will lose the goodwill of its employees because they would no longer trust them. To avoid this situation of trust deficit, every change has to be prospective rather than retrospective in nature. Methodical documentation of every promise becomes imperative here. You wouldn’t want an employee to accuse the company of wrongdoing when it had only been a case of miscommunication.
A good way to do this is by providing an example of how the ESOPs would look like post vesting at the time of joining itself and leave nothing to speculation for later. In another instance, it’s important to show how the ESOPs would be affected in case of a downround and prepare the employee for the consequences then.
Oftentimes, founders feel such employee-leaning policies make it difficult to deal with the bad apples in the team. However, is it worth creating an atmosphere of uncertainty for your entire team by introducing too many discretionary clauses only to handle a few isolated cases? A reward policy with a positive mindset instills confidence in the mind of the employees, and the founder saves himself from unnecessary bleak watercooler conversations and a defeated team morale. This is often the case in B2B companies, where teams are tightly knit and word spreads much faster in the industry.
In cases where employees working for a subsidiary have been allotted stocks in the umbrella entity, there needs to be a clear procedural framework of what would happen to them during events such as an equation. In the absence of this clarity, this group can become a collective bargaining unit, and the founders would have to face public embarrassment.
Cleaning up your act
Sometimes it so happens that founders make a wrong move when the company is set up, allotting a disproportionately high number of shares to early investors or employees. It’s wise to clean it up by Series A by somehow carving out a portion of that stake to plow back into the ESOP pool. This helps a larger number of employees to own a part of the company they are building.
Ideally, it is best to structure discussions around assigning shares to the founding team and senior management on the back of incoming investors. This helps avoid unnecessary friction later.
It makes sense to convert the first or top ten employees to shareholders, but crowding your cap table with more people will end up creating complexities when the company is trying to effect a deal such as an acquisition. It is likely for disgruntled employees to hold a transaction to ransom, and it’s prudent to avoid these procedural issues by keeping your ESOP roster minimum and policies transparent. In fact, one should use townhalls to make employees go through these and ensure they are fully aware of the provisions / rules. This way, founders can reduce their sources of grief later on.
The bottomline is that a robust ESOP framework is a fine balance between logic and emotions.. Being liberal with ESOPs is great, but having a clear and multiple exit opportunity with few tax snags is better. To sum up, make sure you communicate the value of ESOPs clearly so your employees have faith in the company, ensure a three to five year vesting period, and reassess your ESOP policy at every round so there’s no bad blood later.
Written by Disha Sharma