All you need to know about ESOP and how to use it well

By T N Hari
June 06, 2017, Updated on : Thu Apr 08 2021 08:59:59 GMT+0000
All you need to know about ESOP and how to use it well
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Employee Stock Options is a priceless tool for attracting and retaining talent at a startup. So, both founders as well as employees should know how to use it well.

One of the most common problems with stock-based compensation is that most employees and founders do not fully understand it. The founders need to first understand this well, before they can structure offers with a significant stock component or communicate the value and risk associated with options to employees.

Before throwing in options into the mix, you need to first educate the uninitiated candidates.

If you take a one-size-fits-all approach and grant an equal number of options to all individuals, irrespective of their experience in previous organisation or their expectations, you would be unnecessarily giving away a precious resource without getting anything in return. For those that are fixated on cash and are unwilling to budge, you needn’t offer them the same number of options as what you would offer someone who has a bigger risk appetite and comes at lower cash compensation. If you can judiciously discriminate in terms of the grant size, based on the risk appetite of a prospective employee, your options pool will give you a much bigger bang for the buck.

Communicating an offer that has stock options

Never communicate an offer on email in general, and surely not an offer that has a significant stock component. Have a face-to-face meeting or get on a call, if the candidate is in a different location.

In the face-to-face meeting, provide a preamble about the business, the competitive landscape, the journey so far, how the startup and business terrain might look four years from now, the valuation drivers, the projected valuation (provide a range) of the startup at the end of four years, and finally the worth of the stock options on offer (provide a range). Ideally you want candidates who feel excited by your story and excited by your stock. You don’t want people who just say all the right things about stock, but negotiate hard for high cash compensation.

Help the candidate see her total compensation over a four-year period. If she wishes to compare what you have on the table with anything else she may have, help her realise that it is the cumulative four-year earnings potential that she should benchmark.

The options strategy and grant size will depend upon the stage of funding

Let’s first start with a Series-A funded startup and from there go back (seed/angel) and forward (Series B/C).

The options pool post Series A is typically 15 percent of the overall equity pool on a fully diluted basis. Typically, a Series A investor would ask the founders to make the provision. This has serious implications for the founders. Let’s assume that the pre-money value of the startup is $5 million and the founders own 100 percent. The Series A investor would come in and agree to put in, say, $5 million for a 50-percent stake with the proviso that after the investment, the founders would own 35 percent and the balance 15% would comprise the options pool. Obviously, the investor is getting you, the founder, to create the options pool from your equity. So, be wise. If you do not need a 15 percent pool now, just go with, say, a 10-percent pool size. If you need to increase the pool size later on you can jointly dilute with the investor and create the additional five percent.

What should be the quantum of grant? The standard and well-tested practice is to consider anything between one and two percent for a CXO, and between 0.25 and one percent for a key hire one level below a CXO. A professional CEO may need four-eight percent. The bigger the valuation at the time of Series A, the lower the end of the range could be the size of the grant.

Now, you can go back to the seed round. Based upon the extent of dilution expected after Series A, you need to work backwards. If you expect a 50 percent dilution, then the seed round grants need to be double of what they are after Series A.

What should be the strike price? The best approach is to use the current market value. This is a clean design and ensures that those that come in at an early stage see a greater upside even if the grant size is the same as it is for someone who comes on board later. So, the risk takers that came in early have the dual advantage of a greater upside (on account of a lower strike price) as well as early vesting. Some startups tend to use the par value of a share as the strike price. This is not a common practice though. We believe the reason these startups have resorted to this approach is to assign and communicate the dollar value of the options at the time of grant. This makes it easy for someone who has no idea how to value options.

Let us assume that a startup offers a salary of $125,000 plus stock options (with a four-year vesting) whose value is $300,000 at the time of grant. The value of $300,000 is arrived at by multiplying the number of options and the differential between the current market price and the par value. If the grant size is 30,000 options, the current market price is $11 and the par value is $1, then the current value of the options is 30,000*(11-1), which is $300,000. Therefore, the equivalent cash compensation of this offer is $200,000 per annum (which is $125,000+25 percent of $300,000). The obvious error with this approach is that if the share price appreciates (and it is certainly expected to appreciate – and appreciate significantly), this calculation is totally flawed. If the share price quadruples in four years, then the terminal value of the options is actually $1,200,000 and the total compensation per annum is actually $425,000 and not $200,000. The other problem with the exercise price being at par is that irrespective of when a person comes on board, the upside tends to be the same. This is a deviation from the fundamental design principle of an ESOP plan, which is that everyone gets an upside depending upon the value creation that they have enabled during their tenure.

Clauses you need to be aware of as a recipient of stock options

We’ll quickly introduce some terms – but we assume that most readers would have a sense of what they mean and hence would just draw attention to some tricky pieces.

  • Vesting – usual vesting period is four years. Some plans have a cliff of 12 months for the first vesting but have monthly or quarterly vesting thereon. Some other plans are simple and have an annual vesting. Vesting is not a tricky clause.
  • Exercise – the very definition of an option means you have the option of exercising any time after vesting (and before expiry) by paying the strike price (along with any taxes) and acquire the equivalent shares. But remember, some startups (the rare ones), do not allow you to exercise your vested options, and have a clause that says a cashless settlement will be done upon an exit. Such startups do not want the hassle of dealing with a large number of shareholders or share sensitive information with them. This may or may not be important for you depending upon how you choose to look at it. A clause that does not permit an employee to own shares by exercising vested options is personally unacceptable to me.
  • What is the strike price? How does it impact me? Strike price is what you need to pay to convert the stock option to a share. Normally, the strike price is the current market price, but usually it is at a slight discount to the current market price. Periodic adjustments are made, but the reality is that there is a lag. So, if the strike price is $3 and the market price at the time of grant is $4, then the value upon grant is already $1. If the stock price goes up on an average by say 50 percent per annum, then at the end of four years, the share price is 1.5^4*4, which is nearly $20. Since the strike price is $3, the value is $17.
  • Will I get diluted in the subsequent funding rounds? Yes, of course you will. That is the reality. Assume you own a two-percent stake in a company that is currently valued at $50 million. Your value is $1 million. Assume the company raises $25 million at this valuation (pre money value of $50 million). The post=money valuation of this startup is $75 million. However, your value is still $1 million. But, you own a 1.33-percent stake now. Notice that your wealth hasn’t disappeared or shrunk. You just happen to own a smaller stake in a bigger company!
  • What is pre-money and post money, and what are the implications for me? It doesn’t impact you as an employee a great deal. So, don’t bother. You would have figured out from the above example that post-money value of a startup equals the sum of the pre-money value of the startup and the quantum of fund raised.
  • What happens when you quit? This is the trickiest part. Most startups expect you to exercise all your vested options within 30-90 days of separation. This can be financially very onerous, especially if the current market price is much higher than the strike price. Since most employees cannot cough up the required cash to exercise the options, or do not want to be saddled with a risky and illiquid asset, they have no choice but to hang on (if the upside looks attractive), or leave the options on the table and walk (if the value is not attractive enough). Startups can use this to hold on to employees even after options vest without necessarily having to throw in additional hooks by way of fresh grants. Some startups are generous and allow you to exercise vested options anytime before expiry even after separation. This gives a grantee a lot more leeway and flexibility. Why would a startup want to do this? In our opinion, those that do it do so because they believe it is the fair thing to do.
  • What happens if the startup gets acquired before your options vest? Look for a clause on “change in control”. Most startups allow for an acceleration of vesting when there is a change in control (in layman’s language it means an “acquisition”). Some startups allow 100-percent vesting upon a change in control and some others may offer a 25-percent acceleration. The latter is much more common. The 100-percent acceleration is truly very rare because it can deter a potential acquirer by acting as a mild poison pill. A 25-percent acceleration just means that if the startup gets acquired within 28 months of your coming on board, then even though only 50 percent of your options would have vested under a simple four-year vesting plan, the acceleration clause ensures that an additional 25 percent automatically vests (taking it to 75 percent). We know of a high profile startup that did not have this clause. It got acquired in less than 12 months of a good number of senior hires coming on board. When the implications of the fine print became evident all hell broke loose! What was surprising, though, was that senior level hires had come on board without reading the fine print. We have been discovering that this is common practice.
  • In the event of a change in control, what happens to my unvested options? That depends upon the terms of agreement between the two parties to the merger/acquisition. The unvested options may just be forfeited; or, they may be converted into equivalent options of the acquiring company; or a percentage of them may be deemed to be vested and paid off.

Should the strike price be lowered (in other words should the options be re-priced) when the share price or fair market value declines, or if the options go under water? This is only relevant for the founders and the Board.

When options go under water, it essentially means that the fair market value has dipped below the strike price. In other words, the startup has seen a decline in valuation.

In our opinion, options should not be re-priced excepting under the rarest of rare circumstances. Options and stock come with a downside risk. If the startup mitigates this downside risk for employees but continues to allow windfalls when the stock price sees a surge, then it is really taking the risk component out and offering free insurance against a downside. This hurts the other shareholders. Removing the downside for 15 percent of the shareholders (the option holders really) means the remaining 85 percent of the shareholders have to absorb the extra risk burden. This is not fair and creates a misalignment between the interests of the different key stakeholders.

What are the other forms of stock-based compensation?

Restricted stock or RSU is another instrument. Unlike an option, an RSU is a share with some restrictions (usually on when you can sell). Hence there is no strike price. If you are granted an RSU with a 12-month vesting, it just means that you will own a share at the end of 12 months. Unlike an option, an RSU can never go under water because there is no exercise (or strike) price. Therefore, an RSU will always have some value. Most startups prefer stock options in their compensation plans and avoid RSUs. On the other hand, listed companies prefer RSUs. The logic is almost entirely tax related. In the case of an RSU, the tax needs to be paid upon vesting (because you actually own a share), and paying a huge amount of tax for acquiring an illiquid asset does not appeal to anyone. However, if the company is listed, the tax can be paid by selling a portion of the vested lot of RSUs.

The tax treatment varies from country to country, but in every country the tax treatment for RSUs is different from the tax treatment for options.

As an employee what should you do? How should you look at stock-based compensation?

As an employee, the decision to work for a startup should be based only on whether you love working for the particular startup that you are interviewing with – and nothing else. Do you like the people? Do you trust them? Are they fun to be around with and will you learn?

Having decided to work for a startup, you need to take a strategic view of compensation. A strategic view involves computing earnings over a longer term and taking some calculated risks. No one can help you assess your risk appetite better than yourself.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)